As buyers, we become very apprehensive when the price of any item or security appears “expensive”. It is our instinct to search for “deals” and “discounts”. However, it is important to consider the price of the item, relative to its potential value. If we do not widen our horizons we may miss valuable investment opportunities that the seemingly expensive security presents. Every bond has its season, and there are some seasons where the sun indeed shines on bonds priced at a premium (hereafter referred to as “premium bonds”). Clients who value high credit quality should examine the benefits of “premium bonds”.

Bonds can trade at par (100), at a discount (less than 100) or at a premium (higher than 100). A bond usually trades at a premium when it offers a coupon rate that is higher than the prevailing interest rate. For example if a bond has a seven per cent coupon at a time when the current benchmark market interest rate is at five per cent, the bond will be in high demand and investors will consequently “bid up” the price of the bond until its yield to maturity is in line with the market interest rate of five per cent. As a result of the “bidding up” process the bond will trade at a premium to its par value. If an investor buys a bond at a premium and holds it to maturity he will get back the face value but not the premium he paid for it. Yet it still makes sense to buy bonds at a premium in some instances. As explained above, when interest rates go down, bond prices rise. Therefore the price of the bond with the seven per cent coupon identified above, will continue to rise if the market interest rate falls from five per cent to four per cent. In other words, if the investor anticipates that interest rates will decline beyond five per cent, the “premium bond” described above could still rise in price and provide sizable positive returns to the investor. In this scenario, the “premium bond” would be a good investment opportunity.

For investors whose primary goal is high current income then a “premium bond” may be one such way to achieve this. As stated before, the “premium bonds” usually carry a coupon rate that is higher than the prevailing market interest rates. This allows the investor to receive relatively higher cash flows, without taking on additional credit risk. The premium paid at the time of purchase can be recouped over time through the higher coupon payments thereby making the bond attractive.

Investors can also enjoy a lower duration while invested in bonds with high coupon rates, which are usually “premium bonds”. The duration of a bond measures the length of time before the cash flows are received. For clarification let’s use an example, we will assume a low interest rate environment with the 10 year interest rate at five per cent. A bond with 10-years to maturity and coupon of seven per cent would hypothetically be priced at 110. A similar 10-year bond with a four per cent coupon rate may be priced at 99. (Notice investors demand the bond with the higher coupon rate, thereby causing the price to rise above 100). The “premium bond” (seven per cent coupon rate) has a lower duration as the bond will return more coupon income over the period than the discounted bond (four per cent). Lower duration (i.e cash flows received in a shorter span of time) is a benefit because the net present value of the cash flows you receive at any given point in the life of the bond is higher than those received with a bond that has a higher duration (i.e takes longer to distribute cash flows)

There is more to investing than just the price of a security. Clients should take the time to carefully examine the various components of the security (issuer, credit quality, price, coupon rate, maturity etc). It is important to focus on the price of the bond, in relation to its underlying or relative value. Even if a bond is trading above 100, the bond may still be a good buy.

Dian Blackwood is a personal financial planner with Sterling Asset Management Ltd. Sterling provides medium to long term financial advice and instruments in U.S. and other world market currencies to the corporate, individual and institutional investor.

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