Monday, June 17, 2019

At a Premium, But Not Necessarily Over-Priced

Ask the CFP


“Pure mathematics is, in its way, the poetry of logical ideas.” ~ Albert Einstein


Question: What does it mean when a bond is priced at a premium or over-par?

Answer: When discussing bonds, par is the price of a bond when it is issued and also when it matures. During the lifetime of a bond the price fluctuates and is expressed in terms of at par, under par or over par.  Premium is the same as over par and a discount would indicate under par pricing. To help understand this concept and the implications explore an example of purchasing a premium bond. But first, let’s look closer at the term par and bonds in general.

For golfers, par is the number of strokes an expert or scratch golfer uses to complete a whole or an entire course. It’s a measurement used to set a standard for an activity. If someone is feeling under par, they are not likely at their best. Par is a level measuring various conditions.

In the chemistry lab, a bond is an attraction between molecules, ions, or atoms. Bonds are attachments that connect and hold. In literature class, we learn that a bond is a vow, promise, or word of honor. To investors, a bond represents indebtedness between an issuer who is usually a corporation or government entity, and the investor, or owner of the bond. Most often, the maturity date and interest rate or coupon payment are fixed. For this reason, bonds are fixed income instruments.

An item selling for a premium can be thought of as being overpriced and as something to be avoided. The exact opposite I usually true for bond investors. Bonds priced above par offer four significant advantages over discount or below par bonds. The inverse relationship between interest rates and bond prices is one reason.  

First, bonds priced above par or at a premium offer higher cash flows thanks to their above market coupons. Second, availability and selection may be better as premium bonds represent approximately 80% of the domestic investment grade bond universe according to Raymond James Fixed Income Department. Third, these premium bonds are less sensitive to changes in interest rates. If rates go up then prices typically go down to equalize the rate of return on existing bonds and the new issue bonds. Premium bonds are generally less susceptible to price movements and have a lower duration, an important consideration in the current interest rate environment. Finally, and most importantly, bonds priced above par often offer higher yields, all else being equal, when compared to nearly identical bonds.

As interest rates go down over the life of a bond, new bonds may be issued with a lower stated coupon or interest rate. This will cause the price of the existing bond to increase, as there will be greater demand for the bond with the higher coupon.

The benefits of premium bonds are often overlooked. At face value, some fixed income owners incorrectly assume that there will be a “loss” because the bond matures for less than what was paid. This is simply not true and is a common misconception you can use to your advantage. Hopefully the example helps you see how the math adds up and disproves the “loss” myth and proves that premium bonds are priced over par, but certainly not overpriced. Once the math is clear, it’s evident that in the right situations, premium bonds may offer better cash flow, greater availability lower duration and often times higher net yields.

Finally, the joke of the day from my eleven year-old grandson Josh, who was with me as this was being written. He wanted to know what I was doing, and I told him writing a column about bonds above par. He’s an up-and-coming golfer and provided not only his definition of par but his joke as well: “Why do golfers wear two pairs of pants?” The answer is “just in case they get a hole in one!”

The moral of the story is don’t immediately discount premium bonds. Stay focused and plan accordingly.

The opinions expressed are those of the writer, but not necessarily those of Raymond James and Associates, and subject to change at any time. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. All investments contain risk, including loss of principal. Views are as of April 15, 2019 and subject to change based on market conditions and other factors.

“Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, CFP® (with plaque design) and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.”  

This article provided by Darcie Guerin, CFP®, Vice President, Investments & Branch Manager of Raymond James & Associates, Inc. Member New York Stock Exchange/SIPC 606 Bald Eagle Dr. Suite 401, Marco Island, FL 34145. She may be reached at 239-389-1041, email darcie.guerin@raymondjames.com. Website: www.raymondjames.com/Darcie.

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