Profit from Your Premium Bonds

Guy Davidson

When investors see opportunity, we believe they should actively reposition their municipal bond portfolios to take advantage. Often, this requires selling some existing holdings. Today, investors are asking us: Why do you recommend I sell my long-term bonds? They’re yielding 5%. Won’t selling them reduce my potential returns?

These are great questions, and they’re ones we consider in our analyses. Right now we find that many investors own long-term callable bonds that will likely lose significant value when interest rates eventually rise. Our research indicates that there is an opportunity to reduce interest-rate risk and earn similar potential returns by employing active management.

Today, interest rates are near historic lows. That means many investors’ municipal bond portfolios are loaded with bonds worth more than their purchase price because they were bought when yields were higher than they are today.

When the price of a bond is more than its value at maturity (also known as par value), the bond is known as a “premium” bond. Bonds can be sold for more or less than their par values because of changing interest rates.

For example, an airport revenue bond issued only 2½ years ago at $98.5 with a 5% coupon is priced at $108.4 today, and has a yield of 3.7%. This premium bond is expected to pay $100 (par value) upon maturity in 2040.

What makes these airport bonds challenging to value is that they are also callable in 2020. In fact, most long-term municipal bonds are callable. When interest rates descend, long-term callable bonds rally like intermediate-term bonds—because they are priced to their call dates.

Conversely, if interest rates take flight, long-term callable bond values are likely to fall sharply as they begin to price to their long maturity dates.

In this way, long-term premium bonds that are subject to call have the upside of an intermediate bond, but the downside of a long-term bond. This asymmetry of potential returns is most clearly seen in extreme interest-rate movements, as explained in a previous post.

But before that maturity or call date, an investor has the opportunity to sell his long-term bond and pocket a profit.

If an investor takes no action, however, we know how the story ends. He will only be paid par at the maturity or call date—not the higher value. Active managers seek to take these profits and reinvest smartly.

In our view, a smart reinvestment today is in intermediate-term bonds, which offer expected total returns similar to those of long-term callable bonds when you consider both yield and price return from roll.

Roll is the value investors receive as bonds mature and “roll” down the yield curve. As a bond’s yield declines with the passage of time, its price rises due to the inverse relationship between yield and price.

Roll for intermediate-maturity bonds is worth 1.7% today. Together with yield, the expected return of an intermediate bond is 3.7%—essentially the same as the yield of a long-term callable bond. Furthermore, in selling the long-term bond and reinvesting the proceeds in an intermediate-term bond, the investor has reduced his interest-rate risk.

Investors want consistent income and stability from their bond portfolios. By actively redeploying some long-term municipal bonds and navigating to a more attractive part of the yield curve, we believe investors may be able to achieve similar returns and increase the stability of their portfolio.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Guy Davidson is Director of Municipal Investments at AllianceBernstein.

9 comments

  1. ira miller

    Yes, but you give up a full coupon!

    I have many accounts with 15% muni profits, 5% coupons, and 8-10 year call protection. No one wants to give up such a coupon!
    Your idea!
    Thank you,
    Ira Miller, Morgan Stanley,, 585 987 6072

    • Guy Davidson

      We like high coupons with 8 to 10 years in call protection as well, provided the bonds don’t have very long stated maturities. What concerns us about long-term bonds trading to their 8- to 10-year calls is that their value may fall hard when interest rates eventually rise. That is what we mean when we say that they could sell off like a long bond. A premium coupon bond with similar call dates and a shorter maturity offers similar potential return to the long-maturity bond when you consider income and roll, but has significantly less downside risk should interest rates rise.

  2. Good idea, but doesn”t apppear to take into account: (1) the tax aspect on selling the premium bond–15%-20% today–next year?? Clients love great ideas, but loathe the menion of taces–hence the broad appeal of tax free bonds in the first place. 2) The [often hidden] cost of selling the premium bond and buying the new [lower coupon] bond. Often the spreads on selling and buying smaller amounts make such changes financially impractical. And (3) Unless client has enough gain and selling sufficient quantity to buy additional bonds, what does he do with the “profit”? E.g. sells $15M bonds @ 115, gives client $17,250; either needs to add $2,500 to buy $20K, or, of course, invest it all in a mutual fund such as yours.

  3. Note sure if previous message was received. Suggestion does not appear to consider:
    (1) Capital gains tax on selling premium bond
    (2) Cost of transaction (spreads on selling/buying smaller quantities can be significant)
    (3) Unless client sells sufficient quantity to allow purchase of additional bonds, either needs to add money or, of course, buy a mutual fund (such as yours)

    • Guy Davidson

      You are exactly right to consider all the costs associated with a trade, and that includes taxes and the bid/ask spread in the market. With respect to taxes, a number of clients still have loss carry-forwards that could shelter realized gains whether they are realized this year or next. If they don’t, the cost of realizing a long-term gain may be less this year than next, which encourages you to consider making the trade this year. Still, the tax cost and potential trading costs need to be included in the analysis. While long-term and intermediate-term bonds offer similar potential returns in a stable market today when both income and roll are taken into account, the investor has to determine how much they’d pay in taxes and trading costs for the reduced interest-rate risk of a intermediate-term bond. One way to reduce this cost would be to consider reinvesting a portion of the proceeds in a higher-income portfolio…but, that a topic for another post.

  4. Do the think the Fed should end Operation Twist next month?

    • Guy Davidson

      At this point, we don’t believe the Fed will end Operation Twist next month, as previously scheduled. But, Operation Twist will eventually end, which would reduce demand for long-term Treasury bonds. If long-term interest rates rise in response, as we’d expect, investors who sold their long-term bonds today will be comparatively better off.

  5. Sounds good! informative blog about premiums.

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