New York - Municipal bonds priced at a premium — any price above $100 — may prompt some investors to wonder why they would willingly pay more than $100 (also known as par) for a bond that may eventually mature and return only $100. A common question related to this scenario is, "If I pay $120 and get only $100 back, then what happens to my premium?"
The answer is that the investor receives the bond's premium back in the form of extra annual income payments over the life of the bond—a fact that may not be instantly obvious to investors.
Let's look at the mechanics of premium muni bonds to better understand how the premium gets converted to income instead of getting lost in the shuffle and why avoiding high-dollar-price bonds may cause investors to unknowingly pass on purchasing bonds that are among the market's most attractive.
Municipal bond basics
A municipal bond investment is a loan made to a borrower in exchange for interest payments and a return of principal. In the municipal market, borrowers (known as issuers of debt) use loan proceeds to build schools, fix roads or fund hospital expansions. For investors, there are many factors to consider when investing in municipal bonds, including the term or length of the loan or bond, the creditworthiness of the borrower and the expected rate of return.
The rate of return — also called the yield — is determined primarily by the creditworthiness of the borrower. As a rule of thumb, the lower the credit quality of the borrower, the higher the risk and expected rate of return. Other noteworthy factors that go into determining the yield include a bond's structure (which includes maturity date and call features), the state of issuance and the type of bond (such as general obligation or revenue bonds).
The coupon rate is not the rate of return
One additional factor that causes quite a bit of confusion is the coupon rate on a bond. The coupon rate is not the rate of return but rather a fixed payment rate that's promised to be paid annually for the life of the bond. A common misconception among investors is that differences between bonds —including factors such as credit quality and maturity length — are expressed in different coupon rates. That isn't how municipal bonds work. In fact, most munis are issued as a limited range of coupons — usually whole numbers such as 3%, 4% or 5%.
This is perhaps the most important concept to grasp when understanding premiums because the differences between bonds are expressed in the price of the bond, not the coupon rate. A common coupon rate for muni bonds across the entire spectrum of maturity and credit quality is 5%, but it doesn't mean these bonds have a 5% rate of return each year. The market uses price to differentiate among different bonds that pay the same coupon rate. Paying a lower price for a fixed coupon rate increases the yield, or rate of return. Conversely, paying a higher price for that fixed coupon rate lowers the yield, or rate of return.
A premium price indicates a bond's coupon rate is higher than its yield
Another way to think about the relationship of coupon, yield, and price is focusing on the difference between the coupon and the yield. If a bond's price is above par, it's because the coupon rate is higher than the yield. Put differently, the bond is paying a fixed coupon rate that exceeds the rate of return. The excess coupon income an investor receives — the portion of the coupon rate that exceeds the yield — is actually a portion of the premium the investor pays up-front, but it gets returned to the investor through periodic coupon interest payments.
The sample equation below shows that we can approximate the amount of premium being returned annually by subtracting the yield from the coupon rate.
Preserving the premium: Investors have a choice
Once muni bond investors realize their coupon payments may include not only yield income but also a portion of their principal investment, they may reconsider what to take as a distribution. While some investors may want to receive the entire coupon payment, others may choose to preserve the corpus of their investment by taking only the yield income, which corresponds to the true rate of return. Taking a distribution corresponding to the yield only and reinvesting residual coupon income will preserve the entire premium paid at the time of purchase.
Bottom line: Muni bonds have many complex characteristics worthy of careful consideration. Professionals and individual investors alike need to understand the relationship between a bond's yield, price, and coupon rate to make sound judgments. Avoiding muni bonds with premium prices can lead to unnecessarily limiting investment options — and it may ultimately result in passing on opportunities to capitalize on some of the most attractive bonds the market has to offer. Don't fear the premium — high-dollar-price municipal bonds can offer compelling value.