In June, there was a more cautious tone seen in U.S. monetary policy.
Hello this is Natalie Wright, Product Manager at Breckinridge, and welcome to the Breckinridge podcast. Today, we are going to discuss premium bonds, how they work and some of the advantages potentially in investing in premium bonds. Before we begin, please listen to the following disclosure: Keep in mind that our podcast today will include examples in tax scenarios that are for illustrative and informational purposes only. They are intended to be general in nature and are not meant to be investment recommendations or tax advice. Since every investor's financial and tax situation differs, the information we have provided may not be appropriate or applicable to your specific needs. Please consult with your financial and tax professionals before making any investment decisions. I am joined by Matt Buscone, Co-Head of Portfolio Management here at Breckinridge. So Matt, to start out: Could you explain what a premium bond is?
Sure. A premium bond is one that sells at a higher price than its par value or principal amount due to the coupon being in excess of the yield on the bond. Now remember, a bond's par value is typically 100 cents on the dollar, so a bond priced at a dollar price of 103, for example, would be a bond that is trading with a three-point premium to its par value.
Well wait a minute, why would an investor want to buy a bond priced at 103 when they are only receiving 100 back at maturity?
So there are several reasons. Premium bonds can be more defensive in a rising interest rate environment. They are potentially less volatile and they are more liquid as premium bonds are the preferred and prevalent structure in the muni market and we'll dive into each one of those a little bit deeper as we go through the next few questions.
Okay, so if I buy a bond at 103 and it matures at par, is there a loss on that security?
There is not. The extra three points of premium in this example that we're referring to is returned to the investor over the life of the bond in the form of higher coupon payments than you would receive on a par bond. The coupon payment, remember, is comprised of two pieces. One piece of that coupon payment is the yield to maturity on the bond and the other piece is the return of a portion of your principal, so if you let that bond mature, there's no capital gain or loss, and you receive that extra three points of premium over the life of the bond in the form of a higher coupon.
So in addition to the reasons we just mentioned, there are some important tax considerations, is that right?
Yeah, there are. And we know that for many municipal bond investors, tax exemption is one of the most important characteristics of municipal bonds. It turns out that for par or discount bonds, depending on what price that you bought them at, a portion of the income from that bond could be taxed. It makes these type of bonds a little bit more complex to understand for the retail investor.
Okay, could you dive in and explain this a little more?
Yeah, so the IRS instituted a rule back in the early 1990s, which is known as the de minimis rule. If you purchase a bond at a market discount, you must pay ordinary income tax on the difference between the purchase price and a certain value that's dictated by tax rules when the bond matures. So the IRS allows for a quarter point a year based on the time to maturity. If the price falls below that, you pay taxes on the difference between what you paid and the de minimis threshold and then it becomes a muni bond that is partly taxable and partly tax-exempt, not ideal from an investor standpoint.
All right, so if you buy a bond that has fallen from its issue price to say 93, you have to pay tax on the accretion of that bond from 93 to a certain level dictated by tax rules?
Yeah, that is correct. So what happens is when you sell that bond at a market discount, you have to compensate the next buyer of the bond for that tax liability. The bond would, in effect, be discounted even more by the present value of that future tax liability. Now this is slightly less of an issue for longer bonds because the present value is spread over longer periods of time, but for intermediate-term bonds, this can make a big difference in where the bond can be sold and what different investors perceive its value to be.
All right, well, does this impact the liquidity of discount bonds?
Yeah, it does. It means that these discount bonds are often less liquid than premium bonds and remember that the muni bond market predominantly is comprised of retail investors who don't want to be bothered with bonds that have some portion of their income taxed. This hinders the liquidity of the discount bonds versus the premium bonds.
What does this mean then for investors who hold discount bonds?
So it means if you're looking to sell that discount bond, the seller really needs to apply three different layers of discount: The market discount itself, a further discount to compensate the new investor for the tax penalty we just discussed, and then an even further discount to compensate that investor for what they may perceive is lower liquidity for the discount bonds.
Okay, well, are there any other reasons to prefer premium bonds over discount bonds?
So there are, and a lot of this primarily has to do with where we are in today's fixed income market as a whole, interest rates are at historic lows and rate normalization could likely be in the offing as the economy improves and this would be a preferable environment for premium bonds for a variety of reasons. First is that premium bonds have a lower duration due to the higher coupons that they have, discount bonds typically have lower coupons and more of their income is earned at maturity so their duration is longer. The shorter duration offered by premium bonds can help the total return on a bond if rates begin to rise. The second is with higher coupons coming from premium bonds, investors have more money to reinvest quickly to take advantage of potentially higher rates in the broader market and the third is in the muni market, currently, more than 75% of the market is trading at a premium. Five percent coupon bonds are the most prevalent in our market, making them more liquid. And for investors that are steering themselves only to par bonds, you're really limiting the pool of available muni bonds that you can buy as par bonds are typically only available at new issue. So if you're saying I want to buy only par bonds, you're really opening up a very small fraction of the market to your available pool of bonds to be bought.
Okay, interesting. Well, could you run us through an example of a premium bond?
Sure, so let's say you purchase a 10-year 4% coupon bond. We're at a yield of 2% right now and that comes with say a dollar price of 110. If rates in the broader market rise in the near-term to say 2.5% in 10 years, while a premium bond's price will fall, a discount bond's price will likely fall even further as the higher income that's generated by the premium bond helps offset some of the price decline. The tax and the liquidity issues we mentioned earlier also come into play to impact the discount bonds a little bit more negatively.
So in general, it sounds like as rates rise, discount bonds or par bonds will experience a more rapid erosion in price?
That's right, and this is important as we enter an environment that we just discussed where the Fed may be nearing rate normalization. You know the muni market the last several years, we've got low rates, tight spread of credit spreads, and very good liquidity now due to the presence of a tremendous amount of mutual fund inflows, but if that changes, you want to own what the market wants to have and so if you're buying a lot of discount bonds now, if rates start to rise, mutual fund outflows increase, a lot of people aren't going to want those par or discount type structures. You might be stuck holding something that you can't get a bid on that you think it's quite worth so we would say don't stretch for something now, really stick to your knitting and we think premiums fall into that category.
Well, anything else we need to think about in terms of premium bonds?
So there's one thing you can do in the muni market that can be done to help investors that have large taxable gains that can potentially be offset with a loss on the muni side and that's called a tax loss swap. So what you will often see during a year where maybe rates have risen a little bit during the course of the year, an investor will look to sell a bond, capture that loss and replace it with another bond of a similar maturity or credit profile but now if rates have risen, the loss on a par or a discount bond may be too large for the swap to work and it could be detrimental for investors with heavy tax burdens as it makes that swap much more difficult and costly to execute so you don't want a bond that has too much of a loss, you don't want to be giving something away and do a bad bid just to capture a loss, so in essence, you might have a tax loss that you'd like to realize but it's not efficient to get that loss executed.
Okay. Well, to wrap things up, what are our key takeaways?
In a rising interest rate environment, premium bonds may be worth considering as they historically have retained their value more than discount bonds. They tend to be more liquid and can provide certain tax benefits for some investors.
Okay, thanks so much, Matt. We hope that you in the field have found this informative. We look forward to you joining us on our next podcast. Thank you.
DISCLAIMER: The material in this transcript is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Portions of this transcript may have been edited from the original podcast recording to improve clarity of message. Nothing in this transcript should be construed or relied upon as legal or financial advice. This podcast transcript includes examples and tax scenarios that are for illustrative and informational purposes only. They are intended to be general in nature and are not meant to be investment recommendations or tax advice. Since every investor’s financial and tax situation differs, the information we have provided may not be appropriate or applicable to your specific needs. Please consult with your financial and tax professionals before making any investment decisions. All investments involve risk – including loss of principal. This document may contain material directly taken from unaffiliated third party sources, including but not limited to federal and various state & local government documents, official financial reports, academic articles, and other public materials. If third party material is included, it is believed to be accurate, and reliable. However, none of the third party information should be relied upon without independent verification. All information contained in this document is current as of the date(s) indicated, and is subject to change without notice. No assurance can be given that any forward looking statements or estimates will prove accurate or profitable.