Premium Bonds: Higher Price, Better Deal

Shopping for municipal bonds sure isn't like shopping for clothes. The mantra among many apparel buyers is "Never pay full price," but munis are one purchase where you are often better off when you pay a premium.

This is especially true now. For one thing, premium bonds--which sell above their face value because their coupon is higher than prevailing rates--are less sensitive to interest-rate increases than par or discount bonds. That's because they generate a larger cash flow, which can be reinvested at higher rates. All bonds will fall in value if rates continue to increase, "but the downhill slope for a premium bond is less severe," says Eugene Rainis, a partner at Brown Brothers Harriman & Co. in New York.

"CLUELESS." Also, a change in the tax law gives premium bonds even more of an edge over discount bonds. The gain on a discounted bond--the $100 you get at maturity if you pay $900 for a $1,000-par bond--used to be taxed at the capital-gains rate--currently 28%. But if the bond was purchased after Apr. 30, 1993, the gain is treated as ordinary income. This makes a big difference in the aftertax return on discount bonds, especially now that the top marginal rate is up to 39.6%. The tax change also drives down the price of discount bonds "further and faster," says Rainis, since the market will factor in the eventual tax liability. Premium municipal bonds produce no gains at maturity. The higher yield you get each year is tax-free.

Corporate and Treasury bonds selling at a premium also enjoy more price stability than is the case with par or discount bonds--because of their higher annual payments. But only in the municipal market do premium bonds yield substantially more to maturity than other bonds of comparable maturity and quality. This is because the municipal market is dominated by small investors, who often have an aversion to paying a premium--even when it's in their best interests. Since there's less demand for premium munis, buyers get better value for the price.

"Individual investors, for the most part, are absolutely clueless about bond arithmetic" and only want to buy bonds at a discount, says Jay Chitnis, a bond dealer at Stoever Glass & Co. in New York. "Try to sell an 80-year-old client a bond at a 15% premium. It's not going to happen." Premium bonds are also less marketable to trust officers, who have a fiduciary responsibility not to erode the principal of a trust.

With softer demand for premium munis, the yield to maturity--a measure that factors in both the annual coupon payments and any increase or decrease in principal--can be as much as 0.5% higher than for a similar discount muni, says Chitnis. For example, a $10,000 investment in California state bonds with a 7.5% coupon selling at a 14% premium would grow to about $21,330 by the time the bonds matured in 13 years, assuming you reinvest the coupons and rates don't change dramatically. A comparable investment in California munis with a 5% coupon selling at a 8% discount would grow to $20,480, for someone in the 31.7% tax bracket, according to Chitnis.

The same spreads can't be found in the markets for corporate and Treasury bonds, which are dominated by professional investors who won't shy away from a bond just because it is trading above par.

There are some disadvantages to premium bonds. The biggest is that they are subject to calls because of their higher coupons. If you buy a bond at a premium and a year later it gets called, you will be stuck with a loss of principal. Check to see if the bond you're buying is callable. Also, if you spend the income as you get it instead of reinvesting it, you'll end up with less principal at maturity. That shouldn't be too much of a shock, since you'll have been reaping higher coupon payments. And it's less than the shock awaiting discount muni buyers when they learn that the gain on their bonds at maturity--which seemed like such a good deal--will be taxed as much as 39.6%.

      California  Price        Coupon   Before-tax   Aftertax     Price change
      bonds*      (8/14/94)    rate     yield to     yield to     if rates
                                        maturity     maturity**   rise 0.5%
      PREMIUM     $1,064       6.5%     5.80%        5.80%        -4.35%
      PAR          1,000       5.75     5.75         5.75         -5.42
      DISCOUNT       906       4.875    5.90         5.70         -5.55
      *  Noncallable AAA bonds, maturing 11/1/08
      ** For someone in the 39.6% tax bracket

Amey Stone

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