If investors have ever wondered whether it’s worth ponying up a premium for some municipal bonds, we think the answer may often be yes. These defensive bonds seem particularly compelling today, when interest rates remain relatively low and both volatility and income are top of mind.
In the past, some investors may have overlooked premium bonds—bonds that sell for more than their face value, or par—because of the higher price tag. These investors are concerned that they’ll lose their premium when paying a higher price. But the reality can be quite different.
We think premium muni bonds are worth considering for two reasons: First, they can be less sensitive to rising interest rates because of the higher level of cash flow. And second, they may help municipal investors sidestep a complex penalty tax.
In This Case, Bigger Really May Be Better
Let’s go back to the earlier concern. It’s true that investors pay a higher dollar price for a premium bond than they’d pay for a par or discount bond. But premium bonds have the advantage with higher coupons and higher interest payments.
So, a premium bond may deliver the same return as a par bond—in large part because of better income (Display). With a hypothetical $1,000,000 investment in a premium muni bond, an investor gets less face value than he or she would with a par bond. But the higher 5% coupon adds up to a lot more income over time—and ends up delivering the same return.
As a bonus, a premium bond’s higher coupon may help investors get their money back faster than if they owned a par bond. This factor can be especially helpful when interest rates rise, because premium bonds’ increased cash flow can in turn be reinvested at higher rates.
Don’t Be So (Interest-Rate) Sensitive
Premium bonds have historically been less sensitive to interest-rate changes—and have even outperformed par bonds when interest rates rise. At the US Federal Reserve’s most recent meeting, the committee didn’t waver from its plan to raise rates this month.
In contrast, a par bond tends to be more volatile (Display), such as during the Taper Tantrum in 2013, when the market sold off and yields rose. Again, it comes back to the income story: par bonds are at a disadvantage because their lower coupon doesn’t produce as much cash flow as a premium bond. This higher cash flow helps keep the premium bond’s price from falling as fast as that of a par bond.
So, an investor might prefer to pay $1,000 for a par muni bond and be satisfied getting par back at maturity. But in a rising-rate environment, he or she could well be better off buying the premium bond at $1,100 and watching it generate more cash flow through bigger coupon payments.
“Deminimize” This Tax
The potential of premium municipal bonds also comes into play on the tax front.
Most municipal bond investors are familiar with the de minimis tax. This is a tax on gains from the sale of a bond that was purchased at a significant discount from its issue price. The discounted amount is determined by multiplying 0.25 times the remaining years to the bond’s maturity. Because the tax isn’t owed by the current bond holder but by the next bond holder, it hurts the bond’s market value.
A premium bond can provide a better cushion against de minimis than a par bond, because the par bond is likely to reach its de minimis threshold much sooner. For example, a 10-year par bond and a 10-year premium bond have the same 97.5 de minimis threshold. But at a price of 100, a par bond would have only a 2.5 point cushion; a premium bond selling at 116 would have an 18.5 point cushion.
With interest rates rising, discount bonds that were otherwise not subject to the de minimis tax may now be subject to the tax—and some investors who were attracted to the bond’s deep discount may not be aware of this possibility. Investing in premium bonds avoids this scenario.
We think investors who are in the market for municipal bonds that offer attractive income potential and stability should look past the higher cost of premium bonds and give them a chance. Investors will not only reap the benefits of higher coupons and interest payments, they’ll own bonds that have tended to hold their value better in a rising-rate environment than par and discount securities.
This feature can be especially compelling with the Fed poised to hike rates further and with volatility concerns not going away anytime soon.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
Article by Daryl Clements, Alliance Bernstein