You buy a corporate bond at par or at a discount, right? It just seems like common sense. What would lead you to purchase a corporate bond at a premium?
Actually, investors do sometimes buy fixed-income securities with coupon rates above current market rates. If interest rates are on the way up, buying a premium bond when interest rates are still relatively low represents a defensive play. The move does involve risk, however.
The “why” behind the buy. Bond investors pick up premium bonds for two compelling reasons. One, these securities have often provided higher yields than discount bonds or those trading near par value, plus comparatively larger net cash flows. If the above-market coupon rate goes up, the increased coupon income can be reinvested at the correspondingly higher rate. Two, these bonds often turn out to have less price sensitivity. When compared to discount bonds, their duration is lower – that is, their prices are less affected by spiking interest rates.
Say you have a chance to buy one of two individual bonds, both with 10-year maturities. The security offered by Issuer A has a 7.0% coupon, while the security offered by Issuer B has a 4.0% coupon. At a 10-year interest rate of 5%, the bond from Issuer A carries a price of 115.59, but its duration is lower as the cash flow stemming from its coupon is comparatively higher. The discount security from Issuer B carries a price of $92.21 but is also more sensitive to interest rate increases – if interest rates are 1% a year after the purchase, the total return on the bond from Issuer B will be -2.08% for that year. Compare that to -1.42% for the premium bond from Issuer A.
The potential downside. The big drawback in buying one of these debt instruments is the risk that the bond might be called before it matures – that is, the issuer repurchases the bond at par value (or close) and then reissues a new bond with a less attractive coupon. If the issuer exercises the call option, then you are out your principal. (The upside is that when interest rates move higher, the odds of a call get longer. If interest rates decline, you face another potential hazard: the prospect of your cash inflows being reinvested at lower interest rates.)
Downgrade, default and event risks go hand in hand with corporate and municipal bonds, yet it is possible to buy some without call features and/or sinking fund provisions (through which an issuer may “retire” a bond before its maturity date).1,2
The takeaway. From a defensive standpoint, premium bonds usually don’t depreciate or appreciate as much as many bonds do when interest rates rise or fall. So they present a bond investor with potential for stability – a nice feature when interest rates are poised to move.
Investing in bonds may expose the investor to numerous risks including, but not limited to, higher interest rates, economic downturn, credit rating downgrades for issuers, decline of the bond market, and defaults of principal or interest. Interest rates and bond prices typically move in opposite directions, with prices of fixed-rate bonds falling as market interest rates rise and vice versa.