Lost & Found: Fixed Income Purchase Premiums on Maturing Bonds

 

February 16, 2017 [premium bonds, cash flows, par bonds]
Daniel Petrush, CFA


Why worry about paying a premium for bonds? While cash flows may differ, income from premium and par bonds is equivalent, all other variables being equal. Purchase premiums aren’t lost when the bonds mature.

One concern all-too-common among many mutual fund investors isn’t well founded: that price premiums on purchased bonds are “lost” when the premium bonds mature at par. They aren’t.

Low interest rates may price bonds with a $20 point premium or some other large number. But keep macro interest rates in mind. A 5.00% coupon cash flow is received against the backdrop of 2.00% income or yield provided by the market.

Walking through a premium bond’s dollar price amortization is helpful to understand differences between a bond’s coupon cash flow and income.

The coupon is the loan’s fixed contractual interest rate paid per annum, say 5%. Income received from owning a premium bond is dictated by the market’s yield curve and yield spread at the time of purchase, cumulatively 2% in our example below. Income received by the investor is not equal to the coupon cash flow for bonds priced at any level other than par, that is, $100. Note how premium dollars are paid back to investors each year with excess coupon cash flow. Our 5% coupon is greater than market-dictated yield to maturity, 2%. Annual coupon cash flow, $5, less $3 premium amortization establishes income received: $2, or 2% in the premium bond example. Therefore, premium dollars paid for the bond purchased are not “lost” when it matures.

Bonds issued with no premium or discount dollar price are par bonds, or bonds issued with coupon rates equal to their relevant market yield: a lower 2% coupon, and par dollar price of $100. No amortization is removed from the par bond’s $2 coupon cash flow each period. Critically, the investor’s 2% coupon par bond income is identical to the premium bond $2 per year or 2% income, after the premium amortization. Hence, premium and par bond cash flows are different, but the investor’s income is the same if premium and par bonds are purchased with the same yield.

Navigating a low interest rate environment challenges fixed income investors. Avoid the irrelevant distraction of dollar premiums. Instead, focus concern on underwriting, relative value, and diversification goals.

Premium vs. Par: Purchase Premium Dollars NOT "Lost"

Note that simplistic whole numbers are used for the sake of example. Actual amortization arithmetic and dollar prices would be different. Complex structural features, such as call options, puts, and sinking funds, are also not considered for simplicity. Calculations used here assume that market yields remain unchanged over the life of the bond. Although not a realistic outlook, interest-rate changes are not relevant for this stage of our discussion.

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