Municipal bonds priced at a premium—any price above $100—may prompt some investors to wonder why they would willingly pay more than $100 (also known as par) for a bond that may eventually mature and return only $100. A common question related to this scenario is, “If I pay $120 and get only $100 back, then what happens to my premium?” The answer is that the investor receives the bond’s premium back in the form of extra annual income payments over the life of the bond—a fact that may not be instantly obvious to investors.
Let’s look at the mechanics of premium muni bonds to better understand how the premium gets converted to income instead of getting lost in the shuffle and why avoiding high-dollar-price bonds may cause investors to unknowingly pass on purchasing bonds that are among the market’s most attractive.
Municipal bond basics
A municipal bond investment is a loan made to a borrower in exchange for interest payments and a return of principal. In the municipal market, borrowers (known as issuers of debt) use loan proceeds to build schools, fix roads, or fund hospital expansions. For investors, there are many factors to consider when investing in municipal bonds, including the term or length of the loan or bond, the creditworthiness of the borrower, and the expected rate of return.
The rate of return—also called the yield—is determined primarily by the creditworthiness of the borrower. As a rule of thumb, the lower the credit quality of the borrower, the higher the risk and expected rate of return. Other noteworthy factors that go into determining the yield include a bond’s structure (which includes maturity date and call features), the state of issuance, and the type of bond (such as general obligation or revenue bonds).
The coupon rate is not the rate of return
One additional factor—which causes quite a bit of confusion—is the coupon rate on a bond. The coupon rate is not the rate of return but rather a fixed payment rate that’s promised to be paid annually for the life of the bond. A common misconception among investors is that differences between bonds—including factors such as credit quality and maturity length—are expressed in different coupon rates. That isn’t how municipal bonds work. In fact, most munis are issued as a limited range of coupons—usually whole numbers such as 3%, 4%, or 5%.
This is perhaps the most important concept to grasp when understanding premiums because the differences between bonds are expressed in the price of the bond, not the coupon rate. A common coupon rate for muni bonds across the entire spectrum of maturity and credit quality is 5%, but it doesn’t mean these bonds have a 5% rate of return each year. The market uses price to differentiate among different bonds that pay the same coupon rate. Paying a lower price for a fixed coupon rate increases the yield, or rate of return. Conversely, paying a higher price for that fixed coupon rate lowers the yield, or rate of return.