Investing in Premium Bonds: What You Need to Know
Plan a solid investment strategy to help generate consistent income
Did you know that in a low interest rate environment, paying more for premium bonds can be a good investment strategy if you’re looking to generate competitive cash flows on a consistent basis? In this article we’ll explain what premium bonds are and discuss the advantages and risks of investing in them.
What is a Premium Bond?
A premium bond is a bond that trades above its par price in the secondary market. The premium pricing is, in many cases, a result of a falling interest rate environment. Because bond prices and yields have an inverse relationship, when interest rates fall, the cost of bonds rise because the interest rate (or coupon rate) on older bonds is higher than that of newly issued bonds. This makes the bonds more attractive to investors.
Investing in Premium Bonds
Investors are sometimes reluctant to add premium bonds to their portfolios because the amount they pay upfront to purchase the bonds exceeds their par value (the amount paid back when the bond matures). However, depending on an investor’s investment goals, risk profile, and time horizon, paying more for a premium bond can offer various benefits, including:
Greater Cash Flow – Premium bonds typically have higher coupon rates than other bonds selling at a discount or at par. While premium bonds are priced above their initial issuing price, investors can receive higher interest payments over the life of the bond. This tradeoff makes purchasing premium bonds a good strategy for investors looking for a higher source of cash flow at consistent intervals.
Better Price Stability and Liquidity – Compared to securities sold at a discount or at par, premium bonds are generally less sensitive to periods of rising interest rates. Since premium bonds return cash flow more quickly, their prices can adjust at a slower rate during fluctuations in interest rates. Moreover, premium bonds are more liquid in a falling rate environment since investors are willing to pay more money to purchase a bond with a higher coupon payment.
Efficient Tax Strategies – The discount earned through discount bonds—securities purchased for less than the face value—is sometimes subject to income tax or capital gains tax, reducing the value of the bond. Alternatively, premium bond investors may have less overall risk from any associated market discount costs.1
What are the Risks?
While premium bonds can be advantageous to investors looking for consistent income, it’s important to read the fine print. Generally, to realize the advantages of premium bonds, investors need to hold the bonds to maturity.
However, if a bond is callable and the issuer redeems it prior to maturity, a bondholder will miss the high coupon rate and may have trouble replacing the bond with a similar investment that provides the same amount of income and principal.
Investing in premium bonds has its advantages. However, you should consult a financial professional to determine whether premium bonds align with your risk tolerance and tax status. To find out if premium bonds are right for your portfolio, contact HilltopSecurities at 833.4HILLTOP.
1. Investors should consult their investment or tax advisors to identify the most appropriate investment choice.
Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation, market valuations, prepayments, tax ramifications, and other factors.
The value of bonds fluctuates with changes in market conditions. Bonds are subject to market price and availability and are offered by official statement only. When sold, bonds and bond shares may be worth more or less than their original cost. Bonds are subject to price and availability. As interest rates rise, bond prices typically fall, which can adversely affect a bond’s performance. Specific bonds differ in their sensitivity to changes in interest rates depending on their individual characteristics, including duration. Call risks: Declining interest rates may accelerate the redemption of a callable bond, causing an investor’s principal to be returned sooner than expected. Not a recommendation for informational purposes.
*There may be federal, state, local (and/or) alternative minimum tax or capital gains tax obligations to which an investment in the municipal bond may be subject to.
Momentum Independent Network, Inc.(MIN) is a registered broker-dealer and registered investment adviser. MIN is a wholly owned subsidiary of Hilltop Holdings, Inc., (NYSE:HTH) with offices at 1201 Elm Street, Suite 3500, Dallas, TX 75270, (214) 859-1800. © 2021 Momentum Independent Network, Inc., Member: FINRA/SIPC. | All rights reserved.