Check premium bonds for whether they are priced to call or maturity and whether any immediate redemption is near. Buy premium bonds for extra income over the yield of an equivalent par bond. Always consider the credit rating in the purchase of any bond.
Understand that a premium bond is a bond whose coupon exceeds the general level of interest rate. Thus, a par bond represents the general level of interest rates, a discount bond reflects a below market level. As a result, the premium bond has less upside potential but also reduced interest risk. For example, if a 5 percent bond is at par, a 3 percent bond will be a discount, a 6 percent bond would be a premium.
Check the price of the bond. If it is above par (100), then it is a premium bond. Be aware that the purchase of a premium bond now carries certain tax reporting requirements including the amortization (recognition that the bond will pay at maturity less than the purchase price) of the principal over time. Premium bonds are less marketable as well. Because of the premium price, they are probably priced to an earlier call date, rather than maturity.
Know the call feature of any bond you purchase particularly if the maturity is greater than 10 years. The call feature may be at a premium that declines to par over time. Hence, there is the possibility that you will lose the bond to redemption in a period of lower interest rates. Call features give the issuer the right to redeem the bond earlier than the stated maturity.
Purchase premium bonds during a time of rising interest rates. Premium bonds decline in value at a slower rate than lower coupon bonds. In addition, the higher coupon gives you more funds to reinvest at higher rates. To avoid substantial principal loss, buy high coupon bonds of maturities less than 5 years.
Buy non-callable premium bonds to eliminate call feature risk. Premium bonds priced to a call feature trade at a slight yield advantage to par bonds because bond buyers do not like to pay premium prices for bonds. The higher the bond price, the higher the bond premium.
Consider the purchase of premium bonds for a portion of a bond portfolio to maximize income.
Do not buy a portfolio of only premium income bonds. You will probably lose them to early redemption in a period of lower interest rates.
- Consider the purchase of premium bonds for a portion of a bond portfolio to maximize income.
- Do not buy a portfolio of only premium income bonds. You will probably lose them to early redemption in a period of lower interest rates.
After an 18-year career on Wall Street as a trader of municipal and mortgage backed securities, Carmelo Montalbano developed a very large desktop trading application that managed more than 30 institutional portfolios. Technology and small business acquisitions continue to be his primary interest.