Many bond investors are used to the idea of buying a bond at par value (price = $100) and receiving par value back at maturity. The idea of paying a premium, or paying more for a bond than it is worth at maturity, may seem like a bad idea. In fact, premium bonds can be better investments than non-premium bonds in a raising interest rate environment. Premium bonds return higher cash flow to the buyer which shortens the bonds’ duration and makes them less sensitive to interest rate changes.

What is a premium bond?

A premium bond is a bond trading above its par value (e.g. price is more than $100). A bond will trade above its par value when its coupon is higher than current interest rates. If prevailing interest rates are near 3% and a bond has a 5% coupon then buyers will pay a higher price to receive the larger coupon rate. The coupon rate is the amount of interest paid per year to a bondholder. While the coupon on most bonds is fixed, the market price of a security changes based on market conditions. The value of a bond depends on market interest rates, credit quality, coupon rate and maturity date of the bond. While economic and market-driven events impact a bond’s value, the expectation of change in interest rates typically has the strongest influence on bond prices. When interest rates fall, bond prices rise and when interest rates rise, bond prices fall.

Which is the preferred bond to own in a raising interest rate environment?

At first glance, the answer may seem simple — buy the discount bond at $95 and benefit as the price rises to $100 at maturity. Alternatively, paying $110 for a bond that is going to mature at $100 seems to make no sense. But the difference in price is made up for by the higher coupon in the case of the premium bond, and the lower coupon in the case of the discount bond. In other words, the bond trading at a premium will offer higher income payments than the bond trading at a discount, which makes up for the difference in price.

Advantages of buying bonds at a premium:

• Premium bonds have a higher coupon, and therefore return more income to the investor
• Premium bonds are typically less sensitive to fluctuations in prevailing interest rates than similar discount bonds

Disadvantage of buying bonds at a premium:

• Premium bonds require a larger capital commitment up front

A bond’s investment return cannot be judged on price alone. Premium bonds offer a fairly straightforward trade-off: you pay more up front in exchange for larger interest payments. The higher cash flows of the premium bond accelerate the return on your investment. If interest rates are rising, the accelerated return of investment allows for cash to be reinvested at higher rates.

Individual investment positions detailed in this post should not be construed as a recommendation to purchase or sell the security. Past performance is not necessarily a guide to future performance. There are risks involved in investing, including possible loss of principal. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy, security or product described herein. Employees and/or owners of Nelson Roberts Investment Advisors, LLC may have a position securities mentioned in this post. Please contact us for a complete list of portfolio holdings. For additional information please contact us at 650-322-4000.