The premium municipal bond is one of the most misunderstood of all fixed income concepts.
Municipal bonds with coupon rates higher than current market levels are priced above par and many investors mistakenly assume that the premium paid is an irrecoverable loss of principal. The municipal bond will mature at par value or in the case of a pre-refunding, at a smaller premium than they paid for it, so what makes premium municipal bonds a very attractive investment
Why should anyone pay 108 for a municipal bond that matures at par? The premium is what the investor must pay in return for a higher coupon rate than the current market dictates. So, what happens to the premium?
It is returned to the municipal bondholder through that part of the coupon rate in excess of the prevailing fair market rate. For example, if the current market rate is 5% and you purchase a municipal bond with a 6% coupon, you are receiving 1% more than the current market. This extra 1% you receive when the interest is paid on the municipal bond is actually a return of capital as each coupon payment is made. Thus, for income tax purposes, no loss has occurred and the amortization of the premium is not tax deductible. As you receive the additional income the premium is paid back to you, that additional cash flow is the main reason one purchases premium municipal bonds.
The price paid for the municipal bond should be weighed against the time it takes to amortize the premium. Once this occurs, the investor will earn higher tax-free income for the remaining life of the municipal bond
Premium municipal bonds invariably offer more value than par or discount bonds.
Premium municipal bonds invariably offer more value than par or discount bonds. The most obvious factor is the higher “current return” to the investor. It is important to be aware that some of this return is interest earned and part of it is return of capital. When the investor’s yield is calculated on these municipal bonds, the portion that is a return of capital is factored out during the calculation to determine the correct yield on the investment money. This yield will obviously be lower than the current return figure but it is the true yield to the bondholder.
Premium municipal bonds are suitable for the investor seeking higher cash flow from their investment and accept the fact that part of this cash flow until the premium paid is returned, is their own money coming back to them.
Due to widespread misunderstanding of these premium municipal bonds, many investors miss the opportunity to achieve better returns on their investments. Premium municipal bonds offer more protection from market volatility. Because of the larger cash flow, prices tend to adjust less to market movements. They are often referred to as cushion bonds.
Are you ready to learn more about premium municipal bonds and how they offer higher returns? For help with understanding premium municipal bonds, speak with a GMS bond specialist by contacting us online or by calling 877-567-9811.