Premium bonds may offer better relative value
Why premium bonds?
Premium bonds may offer investors a variety of benefits, including:
- Additional cash flow benefits
- Less sensitivity to changes in interest rates
- Prospects for more stable performance in down markets
Premium bonds offer cash flow benefits
Premium bonds offer additional cash flow benefits, which cause these bonds to be more expensive than similar-maturity par bonds. But retail investors’ preference for par-like structures can make premium bonds less expensive than other bonds.
For example, consider a representative utility revenue bond that began trading in May 2018, looking at the relative value of the par and premium bonds:
Because of the coupon structure, the par bond had a duration of 14.15 at the time issuance, compared to the premium bond with a duration of 8.15. For 6 more years of duration, the lower coupon bond offered just 11 basis points of additional yield. Interestingly, the deal came to market with more than $8 million par value in the par bond structure and just over $4 million par value in the premium coupon structure. This demonstrates the higher demand for a structure that investors believe is cheaper. But, on a relative value basis, par bonds may not compensate for the additional interest rate risk.
Premium bonds are less sensitive to changes in interest rates
All bond prices fall when interest rates rise. However, premium bonds return cash flow faster, so their prices tend to adjust more slowly as interest rates change. The longer an investor holds premium bonds, the longer the interest can compound, making it a more important part of the total return. Additionally, premium bonds have historically weathered downturns better than par bonds as can be seen by looking at the downturn periods expressed in the accompanying chart.
While the bonds performed similarly during periods of positive returns, the par bonds underperformed during periods of negative returns (see, for example, the downturns in 2013 and 2017 in the accompanying chart). The par bonds experienced steeper negative returns due to their longer duration and lower reinvestment.
Institutional investors may favor premium bond structures for the same reason that retail investors might favor dividend paying stocks or real estate investors may favor Class A buildings. In each instance, the extra cash outlay upfront has the potential to provide the investor with additional cash flow, via dividends or higher rents. This cash flow can help cushion the value of the investment from adverse future events.
With higher coupon premium bonds, higher initial outlay may lead to more cash flow quicker, as well as better protection against a future rise in rates. If it is necessary to sell the bonds in the future, the marketplace would likely favor the above-market coupon against the competition of newer bonds of the same maturity with higher yields.
In the example above, the par bond’s resulting increase in duration (from 8.36 to 14.03 years) translated to higher volatility for any additional increase in yield. Meanwhile, the premium bond’s duration remained stable (7.73 versus 7.66 years) because the bond was shielded by the higher coupon.
This example of duration extension displays the additional risks associated with investing in par bonds. The par bond’s price sensitivity to changes in interest rates, as measured by duration, increased at the same time that yields also increased. In addition to an attractive duration profile, the premium bond also allowed for more reinvestment through higher cash flow.
During the three most recent periods of extreme interest rate spikes (when the Fed indicated it would slow its asset purchase program in 2013, when bonds prices fell following the 2016 election and when bond supply levels rose in 2018), premium bonds exhibited better relative performance, as seen in the accompanying bar chart. These factors resulted in a more favorable performance for premium bonds in periods of volatility.
Summary
While par bonds may appear to be a better value, premium bonds have exhibited outperformance relative to par bonds over the long term. And premium bonds may offer better relative performance in down markets.