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For munis, understanding premium bonds is more important now than ever

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Christopher J. Harshman, CFAMunicipal Portfolio Manager, Eaton Vance Management

      New York - One of the most misunderstood topics in the municipal market is the premium price that investors pay for the overwhelming majority of municipal bonds. Common questions from investors include: If the bond matures at par, what happens to that premium paid? Is it lost at maturity? If Treasurys, corporate and Agency bonds are issued at par or $100, why do municipals have a premium price in the first place?

      In this blog post, we'll answer these questions to dispel myths, and hopefully bring clarity to the role premium prices play with munis. And importantly, shed light on how an investor can best judge the value, and relative attractiveness of various municipal bonds.

      Why do premium municipal bonds exist?

      First - let us define a premium. It is a price for a bond that is above par, or $100. Using market terminology, a bond priced at $105 has a $5 premium. Conversely, a bond priced at $95 has a $5 discount. Premium or discount prices are the result of a bond's fixed annual coupon rate being different, (higher or lower) than the bond's yield.

      An important point to make is that the yield to worst1 is the true indicator of the return a bond is promised to deliver. However, a bond can be structured to pay an annual coupon rate that is higher, or lower than the yield. In fact, this is how most municipal bonds are created - with an annual coupon rate that is higher than the yield of the bond.

      If the yield to worst is the true indicator of return, how can a bond pay an annual coupon rate that is higher than the yield to worst?

      The answer is in the price. The additional annual cash flow is paid for up front, in the form of a premium price, when the bond is purchased. Note that this is not necessarily a good or bad thing versus a par bond, for example.For bonds that are otherwise similar, bond calculations adjust for differences in both price and coupon, so you can focus on the yield-to-worst.

      How do premium muni bonds affect value?

      Why not issue muni bonds at par? Instead of issuing them with higher coupon rates that result in premium prices? First, premium bonds have less interest rate sensitivity than par bonds, which can be a good thing for investors; the higher periodic cash flows on premium bonds, from the higher annual coupons, return more of the investment more quickly.

      However, the primary reason why the muni market is comprised overwhelmingly of premium bonds, is that premium bonds are less likely to become market discount bonds, thereby protecting investors from market discount taxes, which are not well understood, but can negatively impact municipal bond performance and liquidity.

      If a municipal bond's price falls below par (due to rising interest rates) the next buyer of that bond (not the original holder) is subject to ordinary income taxes on the accrual of the discount back to par. For example - a bond purchased at a market discount of $90 that accrues back to par or $100, would have a 10 point gain, which would be taxed at ordinary income.

      To protect against bonds becoming market discounts and being subject to market discount taxes, investors of all types prefer premium prices when bonds are created or underwritten. This helps explain why 86% of municipal bonds issued in 2018 were issued with premiums.

      A premium price is not a bad thing. Premiums exist intentionally on muni bonds to protect against market discount taxes. When evaluating comparable muni bonds, don't focus on the premium, focus on the yield-to-worst - the true indicator of the return a municipal bond is promised to deliver.

      Bottom line: Relying on yield to worst is just one of the many factors to consider when purchasing premium bonds. We believe security selection will be critical to success when investing in a market as vast and increasingly complex as the municipal bond market. As always, individual investors may benefit from skilled professional management and credit research.

      Investing entails risks including the risk of loss. An imbalance in supply and demand in the municipal market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. There generally is limited public information about municipal issuers. In general, the bond market is volatile. As interest rates rise, the value of certain income investments is likely to decline.