Contributed by: Center Investment Department
Investors often erroneously believe that they will lose money when purchasing a bond at a premium and allow it to mature at a lower par value. In order to understand why this is not the case we should step back and explain some bond basics.
Coupon and Par Value explained
Bonds pay interest to you, the investor. A coupon is simply the amount of money that you receive at each interest payment (typically every six months). Par value, or the issuer’s price of a bond, is typically $1000. If a bond has a 5% coupon, then you receive 5% of $1000 every year; or $25 every 6 months. The price you pay is often expressed as a percent of par value. So if it is selling at $103 you are paying 103% of the par value, or $1,030. (1,000*1.03).
Why would you pay a premium?
When you buy a municipal bond at a premium price (or more than the $1,000 par value), you may be doing so because you are getting a higher coupon rate. For example, let’s say the going market interest rate for a par value bond you are looking at is 3%. If you found a bond that is paying a coupon of 4% with the same maturity you may think, “Jackpot!” However, in order to buy this bond you are going to have to pay more than the $1,000 par value for the 3% bond. To better understand this we use the measure of yield to maturity (the rate at which the sum of all future cash flows from the bond is equal to the current price of the bond). Ultimately, the yield to maturity should be very similar between the two bonds, you will just get more current income from the premium bond as it has a higher coupon, but you pay a higher price to get it. Unfortunately, you don’t get to write off this “loss” when the bond matures and only pays you back the $1,000 par value. The premium of this bond is amortized down each year and is being returned to you in the form of the higher coupon rate. See the example below.
Once the bond finally matures, you have amortized out all of the premium over the life of owning the bond and your cost basis would ultimately be the par value now. Fortunately, you don’t have to worry about calculating this yourself. IRS guidelines require your custodian to calculate and report this on your yearly 1099 Form.
The foregoing 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 statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Tim Wyman and not necessarily those of Raymond James. Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices rise. Investments mentioned may not be suitable for all investors. Investing involves risk and investors may incur a profit or a loss. Please include if clients are able to click on the link: Links are being provided for information purposes only. Raymond James is not affiliated with and does not endorse, authorize or sponsor any of the listed websites or their respective sponsors. Raymond James is not responsible for the content of any website or the collection or use of information regarding any website's users and/or members.