BUYING AND SELLING BONDS
About Premium Municipal Bonds
A premium municipal bond is a security purchased at a price in excess of its par value and with a coupon rate that is higher than the prevailing market interest rate. This means that a premium municipal bond will sell for more than 100 percent of its par value. The illustration below provides a hypothetical example comparing two $1,000 par value municipal bonds maturing in 10 years and not subject to prior redemption.1 In general, premium bonds are less volatile during periods of rising interest rates.
PREMIUM PAR When investing in premium municipal MUNICIPAL MUNICIPAL bonds, investors should consider the FEATURES BOND BOND potential benefits and the potential risks Annual Coupon 5.50% 4.00% associated with these investments.3 There Yield to Maturity 4.00% 4.00% may be tax implications associated with 112.264/ 100/ premium municipal bonds that should be Price $1,122.64 $1,000 considered when deciding on the most Access other Principal at appropriate investment option. Consult Maturity $1,000 $1,000 resources for your investment adviser and/or tax advisor Coupon Payment for additional information. investors in the (annual amount MSRB Education based on 10 bonds) $550 $400 Potential Benefits Center. Premium Paid 122.64 0 Net Cash Flow2 $427.36 $400 Among the potential benefits associated with a premium municipal bond are:
In the example above, which assumes that • Increased Cash Flow — Premium the municipal bond was held to maturity, municipal bonds have higher coupon the higher coupon of the premium rates than comparable securities selling municipal bond resulted in an additional at par or at a discount.4 While premium net cash flow of $27.36 over the life of municipal bonds are priced above par, the bond despite the initial cost being the additional cash inflow received from $122.64 above par value. Note that over the higher coupon may offset the initial the life of the bonds the premium must be higher cost. amortized.
1 All values used are for illustration purpose only. 2 The net cash flow is the total coupon payment of $550 less the additional premium of $122.64 paid at the time of purchase. 3 The MSRB is providing this material for educational purposes only. This information is neither a legal interpretation nor a statement of MSRB policy nor an investment recommendation. If you have questions about premium municipal bonds, please consult your investment adviser and/or tax advisor. 4 Discount is the difference between the price paid for a bond and its par value or compound accreted value.
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© Municipal Securities Rulemaking Board 2018.1 1 • Reduced Volatility — Since premium of fixed income security, premium municipal bonds have higher coupon municipal bonds may be harder to rates and larger cash flows, the price trade depending on the interest rate sensitivity to movements in interest environment at the time of sale. rates is lower. Consequently, their prices • Reinvestment Risk — The risk that tend to increase or decrease less rapidly interest rates may be lower than the than comparable securities sold at par yield on a fixed income security when or at a discount. the owner seeks to reinvest interest There may be • Tax Protection — In certain income received from the security. The tax implications circumstances, the discount associated term also sometimes refers to the risk associated with with purchasing discount municipal that principal repayments on such a bonds may be subject to either capital security may be paid prior to maturity premium municipal gains tax or be taxed as ordinary (e.g., at call date), thereby forcing the bonds that should income and as a result the market owner to seek reinvestment of principal be considered. value of these bonds will be reduced. at a time when interest rates may be Premium bonds may provide investors lower than the rate that was payable on with protection from any associated the security. During a period of falling market discount costs. interest rates, the income stream of a premium municipal bond may have to Potential Risks be reinvested at a lower interest rate. Among the potential risks associated This risk effects all coupon bearing with a premium municipal bond are the fixed income securities, but is greater following: for premium bonds relative to par or discount bonds. Interest Rate Risk • — As with all fixed • Call Risk — To the extent that the income securities, the value of a bond premium bond is subject to redemption will change due to a change in the prior to the stated maturity date, the overall market interest rate. Although risk that the issuer will use a redemption premium municipal bonds have less feature to redeem the bond prior to its price sensitivity to a change in interest final maturity. If a premium municipal rates than par bonds, overall interest bond is called, the proceeds may rate risk should be considered when have to be reinvested at lower interest investing in any type of fixed income rates. Investors should consult with instrument. their investment advisers to better • Secondary Market Risk — The risk understand the relationship between that an investor will not be able to call dates, yield-to-call, yield-to-maturity trade a bond in the secondary market. and premium municipal bonds. While such risks exist for any type
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About Premium Municipal Bonds 2 Reported Yield on Statements payment on a premium bond is actually the return of principal. There are tax Premium bonds have higher coupon implications that should be considered payments and as a result can generate and discussed with your tax advisor and/or greater cash flow. However, investors investment adviser. should remember that part of the coupon
Here’s an example:
An investor has two options in the market when buying $10,000 par amount of bonds. Both are ten-year bonds that are not subject to prior redemption: one is priced at par and one is priced at a premium.
YIELD TO INITIAL TOTAL COUPON INITIAL VALUE AT BOND COUPON MATURITY BOND PRICE PAYMENT CASH FLOW MATURITY ABC 3.00% 3.00% $100.00 $3,000 -$10,000 $10,000 DEF 5.00% 3.00% $117.13 $5,000 -$11,713 $10,000
In the example above, although the The annual income estimated on an coupon payments on premium bond DEF account statement is provided on a pre-tax are $200 more per year than par bond basis, and the Internal Revenue Service ABC, some of that is attributable to the requires amortization of the municipal premium paid upfront to purchase the bond premium although the municipal bond with the higher coupon. Remember, bond’s interest is not federally taxable. both bonds pay back the same principal Although the municipal bond’s interest is amount of $10,000. It is important to not federally taxed, the interest and annual note that although bond DEF’s coupon amortized amount of the premium bond payments over the life of the bond are is required when filing tax returns. Your $2,000 more than bond ABC ($5,000 – investment adviser or broker can provide $3,000), this is partially offset by the the annual amortized amounts. $1,713 premium paid at the time of Consult your investment adviser and/or purchase.5 tax advisor to discuss the potential tax implications associated with premium municipal bonds.
5 Note calculations assume that all principal and coupon payments are made in full and as scheduled.
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About Premium Municipal Bonds 3