Premium Bonds: A Higher Income Option for your Portfolio
Increasing signs of an improving economic environment have helped push corporate bond prices higher. Many prices have risen well above the original $1,000 par value, especially for bonds that are noncallable or have a make-whole call provision. This price jump is primarily due to stronger economic growth that historically tends to reduce the risk of bond defaults. As default risk decreases, you tend to see more demand for corporate bonds and a general narrowing of the “spread,” or difference between rates of Treasury bonds and corporate bonds.
The Price Is Right
Between the issue date and maturity date, a bond’s price will fluctuate from its original $1,000 par value. When a bond is selling at a price below par value (such as $950), it’s selling at a discount. Should it sell at a price above par (such as $1,040), it’s called a premium bond. Bond price changes are primarily due to changes in three factors:
- Interest rates
- Credit quality
- Length of time until maturity
Since a bond’s interest rate and maturity date are fixed, the price is the only component that reacts to changes in any of these variables. With interest rates fluctuating frequently, it’s common for all bonds to trade at a discount or a premium over time. As interest rates go up, bond prices generally go down and vice versa.
A Closer Look at Premium Bonds
Higher rates and income are your benefits for paying a premium price for bonds. For example, if current rates for bonds priced at par value are 5%, rates for premium bonds could be 5.10% or more. If you’re a long-term investor whose primary consideration is income, premium bonds may be attractive to you.
The Best Offense Is a Good Defense
In addition to an income advantage, premium bonds can also provide a good defense against interest rate fluctuations. The sooner bond owners receive interest and principal payments, the less effect changes in interest rates have on bond prices.
Premium bonds pay a greater proportion of their principal and interest payments prior to maturity because interest payments are higher. Consequently, their prices tend to be more stable than those of discounted or par bonds. Should interest rates rise, the prices of premium bonds wouldn’t decrease as much as those of discount or par bonds, and conversely, if rates fall, premium bond prices wouldn’t increase to the same degree.
Check on Call Protection
It’s important to know whether premium bonds can be redeemed or called prior to maturity. If interest rates fall, there’s a greater likelihood that bonds will be called. As a result, it’s best that they have at least some limited call protection to help ensure your income has a higher degree of stability. In that way, should there be an early and unexpected call, it may help you avoid having a loss of principal.
Put Premium in Your Portfolio
Premium bonds can be appropriate for you if you’re looking for higher income or concerned about price stability, provided call provisions are considered and they are part of a well-diversified portfolio.
Mario D. De Rose, CFA
Fixed Income Strategist
Past performance does not guarantee future results. You should understand how various fixed-income risks, including market risk, interest rate risk, credit risk and reinvestment risk, can impact your portfolio.
