Are the values of premium muni bonds worth the cost to investors?
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
The coupon rate is not the rate of return
A premium price indicates a bond’s coupon rate is higher than its yield
Sample equation of annual premium return
Preserving the premium: Investors have a choice
Once muni bond investors realize their coupon payments may include not only yield income but also a portion of their principal investment, they may reconsider what to take as a distribution. While some investors may want to receive the entire coupon payment, others may choose to preserve the corpus of their investment by taking only the yield income—which corresponds to the true rate of return. Taking a distribution corresponding to the yield only and reinvesting residual coupon income will preserve the entire premium paid at the time of purchase.
The bottom line
Muni bonds have many complex characteristics worthy of careful consideration. Professionals and individual investors alike need to understand the relationship between a bond’s yield, price, and coupon rate to make sound judgments. Avoiding muni bonds with premium prices can lead to unnecessarily limiting investment options—and it may ultimately result in passing on opportunities to capitalize on some of the most attractive bonds the market has to offer. Don’t fear the premium—high-dollar-price municipal bonds can offer compelling value.