Why Pay a Premium for a Bond?
Posted by Al Schiliro, Senior Investment Officer, Catalyst Corporate FCU on 8/22/2019

Many credit union investment managers cannot justify purchasing a bond for more than its principal amount, believing that buying a bond at its original price (par $100) or at a discount (paying less than par value) is always the best “deal.” However, in many instances, buying a bond at a premium (paying more than par value) can be more advantageous to the investor.

Premium bonds can provide:

  • Higher yields. Premium bonds tend to yield more than comparable issues selling at discounts.
  • Potentially better pricingfor the simple reason that many investors avoid them. Some dealers will offer these bonds at a slightly better price in an effort to sell them.
  • Greater cash flow and reinvestment opportunityAlthough purchasing a premium bond requires a greater initial investment, the higher initial cost can be offset by higher cash inflows throughout the life of the bond. This can be an appropriate tactical response in a low interest rate environment. The greater cash flow provides more funds to reinvest, creating a compounding effect.
  • Reduced price volatilityGreater cash inflow resulting from the premium bond reduces the bond’s duration, which is a measure of the price sensitivity. Generally, the lower the duration, the lower the interest rate risk of the bond price.
  • More income in a falling interest rate environment. With rates falling, income and cash flow become harder to generate.  

It’s important that investors understand how premium bonds work and the benefits they provide. Bonds bought at a premium can actually help reduce volatility, generate greater cash flow and even provide higher yields.

Premium bonds, those that sell for a price above par value, have a coupon rate above current market yields. The premium paid at the time of purchase is recouped through higher coupon payments, which makes these bonds potentially more defensive against a possible rise infinancing-2379782_640 interest rates. Historically, these bonds have also offered higher yields than those that trade closer to par or at a discount. The investor receives high-current cash flows, and these securities are, therefore, potentially less sensitive to price changes due to interest rate moves. All other variables being equal, bonds with higher coupons should be less price sensitive than those with lower coupons.

Another type of premium bond, a “cushion bond,” is a callable bond that trades at a premium and often offers higher yields than its non-callable counterparts. This is done to compensate an investor for the potential of a call. In a rising interest rate environment when the potential of a call typically diminishes, these bonds also provide a bit of cushion, as they tend to remain relatively stable and depreciate less in price than comparable non-callable bonds with lower coupons.

Ultimately, bonds selling at a premium are more “defensive” in nature than their discount counterparts and should decline less in price than a similar bond selling at a discount. Investors pay more for premium bonds because they receive an above-market coupon rate, higher income and cash flow. And although often avoided, these securities offer several benefits including: lower price sensitivity (duration) than similar discount bonds, high coupon cash flow, and the opportunity to reinvest these larger cash flows, creating a compounding effect.

Catalyst Corporate’s highly-skilled team of investment officers offer an extensive wealth of knowledge on a wide range of brokerage services, including premium bonds. As trusted partners, they are ready to help credit unions attain their goals by creating individualized solutions.

All securities are offered through CU Investment Solutions, LLC. (ISI). The home office is located at 8500 W 110th St, Suite 650, Overland Park KS 66210.  ISI is registered with the SEC as a broker-dealer under the Securities Exchange Act of 1934. ISI also is registered in the state of Kansas as an investment advisor. Member of FINRA and SIPC. All investments carry risk; please speak with your representative to gain a full understanding of said risks. Securities offered by ISI are not insured by the FDIC or NCUSIF and may lose value. All opinions, prices and yields are subject to change without notice.

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