Getting Past Premium Bond Prices

Investing in fixed income seems to be straightforward: An investor buys a bond with a face value of $100, receives semi-annual coupons for the life of the bond, and receives the face value of the bond at maturity.

Besides the investor looking to ‘trade’ bonds for a quick profit, most bond investors are looking for either income, preservation of capital, or a combination of both. For these investors, if bonds were always trading at 100, life would be easy. If a bond always traded at 100, for example, the expected return on that bond would equal the amount of the coupon.

But bond prices fluctuate just like any other security, and although they do not have the price volatility of equities, bond prices can deviate quite a bit from their initial issue price, affecting the expected return, or yield to maturity on the bonds.

It is this deviation from par that many bond investors find challenging. Ironically, the problem isn’t so much when prices are below par, but rather, when the price of a bond is above $100. You see, many investors are philosophically opposed to paying more than $100 for a bond. The concept of paying $110 for a bond today and receiving only $100 at maturity, even if maturity is many years away, would imply a loss of capital of $10. The coupons received over the years are either forgotten or ignored.

Unfortunately, avoiding the bonds priced at a premium simply due to price often leads to less than optimal decision-making when it comes to investing in fixed income and is, to be direct, the wrong approach. Psychologically, It doesn’t help that account statements only show the price changes of the bonds and do not include the coupons received as part of the performance calculation for each position. In other words, an investor may look at their account statement and it will reflect a $5 loss on a bond purchased at 105 and currently trading at 100. The statement won’t include any coupons received as part of the performance calculation for that bond, even though the cash was received in the account. If the bond paid a 5% coupon, the investor would have received $15 over a three year holding period. So technically, the profit on the position should be $10, ($15 in coupons – $5 price loss = $10)  but an investor would have to manually calculate the cash flows to determine the accurate return on that bond. Very few investors do that.

Why Premium Bonds can be better?

Bonds selling at a premium to par simply put, are selling at a premium because they are better than other bonds and there is higher demand for them, than demand for those selling at a discount, all else equal.

Some of the benefits of premium bonds are the following:

  • Because the yield to maturity of a bond declines as the price increases, a bond selling above par will have a higher coupon rate than the yield to maturity.
  • A second benefit of premium bonds is that they are probably offering a higher coupon than rates available in the current market for bonds with comparable duration. And not only does this provide a higher cash flow, it also allows investors to reinvest those cash flows at higher rates. Furthermore, bonds with higher coupons are less sensitive to interest rate increases.
  • It may also be assigned a higher credit rating than comparable bonds, which would imply lower credit risk.

Taking a look at the Cisco (CSCO) bonds listed below, we see that the CSCO 4.95% bond with a maturity date of 2019 is trading at $114 and has a yield to maturity of 1.97%. By comparison, the CSCO 3.15% bond maturing in 2017 is trading at $107 and has a yield to maturity of 0.87%. Even though an investor might be paying $8 more and extending maturity by 2 years, the investor will be receiving a coupon that is almost 2% higher. All else equal, the only reason an investor should choose the 3.15% bond is if there maturity constraints and a 2019 bond is too long.

CSCO Bonds

Pick the best bonds

In the table below, we have included some but not all of the details of two bonds. The first bond has a yield of 4.22% and duration of 4.6 years, while the second bond has a yield of 3.72% and duration of 8.25 years. They have comparable credit ratings and are both guaranteed by their respective issuers. (Same level of seniority within each issuer) The first bond is also part of a much larger issue and pays a coupon that is almost 5% higher than the second. Which bond would you prefer?

Bond Premium Comparison

The clear winner is bond 1, with a yield to maturity of 4.22 and a coupon of 7.875%. It also has a shorter duration and a larger issue size. So what’s the catch? Would it make a difference to you if the first one has a higher price than the second? What if it were priced at a premium to par?

Well, the first bond has a price of $117, while the second bond has a price of $94. Knowing that, many investors would shy away from bond 1 and would prefer to invest in bond 2, if these were the only two options. The thinking is that if they buy bond 2 for $94, they will receive $100 at maturity (a $6 gain), in addition to a series of 2.95% coupons. Unfortunately, if this bond were held to maturity, the return on the investment, including price appreciation and coupons, would be just 3.72%. (the yield to maturity)

On the other hand, investing in bond 1 at $117 and receiving $100 at maturity in addition to a series of 7.875% coupons over the life of the bond, the return would be 4.22%. A full 0.5% higher than bond 2. The account statement, as previously mentioned, will reflect a price decline of $17 on the position and even though the coupons would hve been received into the account, they are not ‘attributed’ to the individual bond performance.

Notice also that the coupon on bond 1 is a full 3.5% higher than the yield to maturity, while bond 2 has a lower coupon than yield to maturity.

Unfortunately, many investors would still choose bond 2 because of the discounted price, and that would be a mistake.

Getting past the psychological barrier

Even though it is very difficult to get past premium bond pricing, investors should reconsider their approach to fixed income investing. We are not proposing that investors always invest in premium bonds. In many cases, premium bonds may be overvalued, in which case, it would be reflected in the yield to maturity it offers. (The yield to maturity would be too low compared to similar bonds)

The proper approach is to look at all the other characteristics of the bonds being considered for investment, without regard to price, as we did with the table above. Only when a bond has been identified as a candidate to add to one’s portfolio should the price then be determined, and only to make the purchase, not to decide whether to invest or not.