Premium bonds, those that sell for a price above par value, have a coupon rate that is above that of current market yields. The premium paid at the time of purchase is recouped through higher coupon payments which make these bonds potentially more defensive against a possible rise in interest rates. Historically, these bonds have also offered higher yields that 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. Price sensitivity to changes in interest rates is referred to as duration, where a duration of 3.00 would result in approximately a 3.00% loss (gain) in principal if interest rates increased (declined) by 100 basis points (1.00%).
Three important benefits of premium bonds are:
Let’s look at a basic theoretical example to help clarify the defensive nature of premium bonds. We’ll assume that the interest rate for 10-years is at 2.37%, thus a bond with 10 years to maturity and a coupon of 6.125% would be priced at 132.08. A similar maturity bond with a 2.25% coupon, lower than the current market rate, would be priced at a discount or $98.86. It should be noted that the premium bond has a lower duration (7.6) than the discount bond (8.5) as it returns more money in the form of coupon cash flow than its counterpart. To illustrate the effects on the price for each bond, let’s assume that interest rates go up by 100 basis points (1.00%) 1 year into the holding period. Should this occur, the discount bond would lose 8.11% in price ($90.93 from $98.96) lose only 7.23% in price ($122.52 from $132.08).
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Source: Bloomberg LP, 1yr horizon, 100bp shock analysis
Another type of premium bond, “cushion bonds”, are callable bonds that trade at a premium and often offer higher yields than their non-callable counterparts. They do this 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. However, after the non-call period, lower interest rates will most likely trigger the call which is at the issuer’s option. Consequently, the investor may be faced with the loss of a higher coupon, and be subject to reinvestment risk.
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. The reason that investors pay more for premium bonds is that they receive an above-market coupon rate. In summary, benefits of these securities include: lower price sensitivity (duration) than similar discount bonds, high coupon cash flow, and the opportunity to reinvest these larger cash flows at higher rates should prevailing interest rates start to increase.
Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration.
This discussion assumes no change in other variables such as credit etc.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Past performance is no assurance of future results.
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