Municipal Securities - Muni Pricing
Implications of Premium Muni Pricing
You might think it is a good thing when your client holds bonds that are trading at a premium. After all, if your client holds a stock that is trading at a premium to the purchase price, your client's portfolio has gained value. However, you must remember that, with bonds, dollar price and yield price move in opposite directions - and it is yield that matters most. Therefore, a bond trading at a premium to par value is actually yielding a lower interest rate.
Making matters worse for investors holding bonds at a premium: that premium must be written off annually, but that write-off is not tax-deductible. So not only do premiums hurt the yield once by effectively lowering the interest rate, they hurt it again by interfering with the tax advantages of munis.
Implications of Discount Muni Pricing
Discounts, on the other hand, have the effect of raising the effective yield; the bond costs less, but your client is still getting the same interest payment in dollar terms.
In addition, the tax laws reward the winners here as surely as they punish the losers holding premium bonds. Discounts are accreted on an annual basis, but are not taxable until sale or redemption. However; the difference between the discounted price and par value is treated as a capital gain for individuals - though it is generally taxed at a lower rate than regular income. Consequently, institutions must treat gains from accretion of discounts as ordinary income.
Whether your client holds a premium or discount muni, the coupon interest is, of course, tax-exempt - after all, that is the whole point of investing in munis.