Buying bonds at a premium? Note these 4 things

By Richard Barrington | July 30, 2014 AAA

Would you buy an investment that was guaranteed to go down in price?

Oddly enough, millions of investors do that regularly when they buy bonds at a premium. A premium means paying a higher price than the maturity value of a bond.

Why would anybody do that? A bond is likely to trade at a premium if its interest coupon is higher than prevailing interest rates. For example, a bond with a coupon of 8 percent and a face value of $100 is likely to trade well above $100 if prevailing bond rates are around 4 percent. Effectively, the price will rise until the coupon represents a yield-to-maturity similar to prevailing market yields.

The outlook for buying at a premium today

Because interest rates have generally fallen over the past 30 years, many bonds outstanding today (especially those with older issue dates) have coupon rates higher than today's yields and thus are likely to be trading at a premium. When buying these bonds, you will get a higher coupon rate, but between now and the bond's maturity, you will see the price steadily drop toward face value.

Here are four things you should consider when buying bonds at a premium:

  1. You may be limiting your upside. Like savings accounts, yields on bonds move up and down as market interest rates change. Unlike savings accounts, bonds do this through changes in price, with rising interest rates driving prices down. While bonds also have the potential to see an interim gain in prices if interest rates fall, this potential is greater for bonds trading at a discount than those trading at a premium. So, investing in bonds at a premium may limit your potential to earn more than the yield-to-maturity when the investment was made.
  2. Lower volatility. On the other hand, because of their higher coupons, bonds trading at a premium have a lower effective duration than bonds trading at a discount, and thus are likely to have less price volatility.
  3. Cash-flow management. Investing in bonds at a premium may be helpful if you are trying to match interest income with periodic payments you have to make. Though you will pay more upfront, the higher coupon on a bond at a premium may better match your payment obligations.
  4. Tax complications. Because of their higher interest coupons, bonds at a premium will subject you to more of a year-to-year tax obligation than bonds at par or a discount. You can offset this tax disadvantage if you amortize the premium you paid over the life of the bond, but you need to be prepared for this added level of tax complication.

If you are simply searching for yield, keep in mind that the best CD rates might rival bond yields at some maturity lengths. The difference is, while the yields may be similar, bonds are subject to price fluctuations between now and maturity, while CDs will have stable values. It's up to you to decide whether those price fluctuations will work out in your favor.

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