Investor Ph.D.: Paying a Premium

Co-Contributed by: Angela Palacios, CFP®Angela Palacios and DewRina Lee DewRina Lee

We aren’t talking Healthcare or Prada even, though you pay premiums for both. Rather, we are discussing why investors may pay a premium for bonds. Bonds are frequently purchased at prices below or above par; that is, at a discount or a premium. Bonds trade at a discount when the coupon rate is lower than the market interest rate, and they trade at a premium when its coupon rate is higher than the market interest rate.

For the purpose of this blog, we will be focusing mainly on the reasons behind why someone may choose a premium bond.

Take the following scenario:

Intuition seems to indicate that when deciding between a discount bond at a price of $970 and a premium bond at a price of $1,030, an investor should take the discount option. It’s always more fun to buy that Prada purse when it’s on sale right? But, there are times when you may want to pay the higher price, for example, if you want the latest season’s purse rather than last seasons.

But enough about my purse addiction, let’s get back to bonds. If the bond matures at $1,000, a discount bond holder who bought at $970 will be pocketing $30 while a premium bondholder who paid $1,030 will be losing $30, right? Not exactly. The higher price a premium bondholder has paid is made up for by the higher interest payments they will earn along the way. In many cases, the additional cash flow more than pays for the cost of the premium price paid up-front. Take a look at the following example:

Additionally, due to its larger cash flows, the time it takes to repay the initial investment is shortened. With all else equal, the higher the coupon rate, the shorter the duration. As such, premium bonds can be more defensive in a rising interest rate environment and potentially less volatile. Also, this larger cash flow allows investors to reinvest more in new bonds to capture potential rate increase. By no means does this mean that premium bonds are immune to rising rates; however, they may offer a way to capture the higher yields with some degree of downside protection in a declining market.

So why pay a premium? In essence, there are a few advantages of buying premium bonds:

  • Higher coupon rate
  • Shorter duration to pay off your initial investment
  • Less sensitivity to fluctuations in interest rates
  • Opportunity to reinvest at a potentially higher rate.

Of course, there are additional risks and financial objectives that are personalized to each individual. Contact your financial planner to figure out how bonds may fit into your personalized financial plan!

Angela Palacios, CFP® is the Director of Investments at Center for Financial Planning, Inc.® Angela specializes in Investment and Macro economic research. She is a frequent contributor The Center blog.

DewRina Lee is an intern at Center for Financial Planning, Inc.®

This information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete; it is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investments mentioned may not be suitable for all investors. Opinions expressed are those of Angela Palacios and DewRina Lee and are not necessarily those of Raymond James. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise. There are special risks associated with investing with bonds such as interest rate risk, market risk, call risk, prepayment risk, credit risk, reinvestment risk, and unique tax consequences. The example provided is hypothetical and has been included for illustrative purposes only, it does not represent an actual investment.