Premium Bonds Help Reduce Unintended Risks
In our view, by sidestepping premium bonds, investors may be taking on three unintended but avoidable risks that primarily affect discount and par bonds.
First, par bonds tend to be less liquid than premium bonds. The premium bond pool is huge, comprising 80% of the $4 trillion muni market. This makes premium bonds quicker to transact—an especial advantage in challenging market environments.
Second, premium bonds have lower extension risk. Extension risk is the risk that, as yields rise, a bond goes from being priced to its call date to being priced to its maturity date, which can add unwanted interest-rate volatility. Since most of the municipal market is callable, this is a critical hazard to watch for when choosing municipal bonds.
Third, extension risk also has the potential to induce what’s known as the de minimis tax.
What’s the De Minimis Tax?
The de minimis tax applies to gains from the sale of bonds purchased at a significant discount to their issue price. The discounted amount is determined by multiplying 0.25 by the remaining years to the bond’s maturity. Because the bond buyer, not the seller, is on the hook for the tax, a bond’s exposure to the de minimis tax hurts its market value.
A premium bond can provide a better cushion against the de minimis tax than a par bond, because the latter is likely to reach its de minimis threshold much sooner. For example, a 10-year par bond and a 10-year premium bond have the same $97.5 de minimis threshold. But at a price of $100, a par bond would have only a 2.5-point cushion; a premium bond selling at $106 would have an 8.5-point cushion.
With interest rates so high today, many discount bonds may be subject to the de minimis tax—something investors attracted to deep discounts may not be aware of. Investing in premium bonds typically avoids this scenario.
We think muni investors seeking attractive income potential and stability should understand a bond’s broader risks and return potential. This includes looking beyond price, which doesn’t necessarily correlate to future returns. Premium, par and discount bonds can all make sense for investors, depending on the environment. But thanks to their higher coupons, premium bonds can potentially perform as well as, or better than, par and discount bonds, making them attractive additions to a tax-advantaged strategy in practically any market climate.
The authors would like to thank Matthew Appelbaum, Product Manager—Fixed Income at AB, for his research contributions to this blog.