People often buy bonds to increase their returns. With so many bond-buying strategies available it’s critical for you to know what types of bonds you should buy.
When you should pay more for bonds
A premium bond costs more than its par (face) value, which means, for example, that you might pay $1100 for a bond that will only pay you back $1000 when it matures. Why would someone pay more for a bond than its face value? Because the annual income it pays you is higher than what other bonds pay. The difference between the face value and the original cost is called the “premium,” and this is what you lose when you buy a premium bond. In general, you more than make up that loss by receiving an above-market interest rate while you hold the bond.
If you want to receive a predictable cash flow at rates that are higher than current bank interest rates, consider the advantages of premium bonds:
• Premium bonds sometimes trade for slightly lower than expected, since many people don’t like paying more than the face value.
• As premium bonds pay a higher coupon rate than discount or par bonds, you receive more cash in your hand each year.
• When interest rates are increasing, premium bonds can make sense. If you hold a bond with a 7% coupon while your neighbor keeps his 4% issue, as rates move up to 7% and beyond, your coupon will seem more in line with general expectations compared with his lower coupon of 4%. That higher coupon may cushion your bond, helping it retain more of its value than its lower coupon counterpart.
Bonds have risks and are not for all investors. But if you’re seeking higher income, ask your advisor if premium bonds make sense for you.
For more information about stocks and bonds, listen to this podcast.
Douglas Goldstein, CFP®, is the Director of Profile Investment Service, Ltd., which specializes in helping people who live in Israel with their US dollar assets and American investment and retirement accounts. He helps olim meet their financial goals through asset allocation, financial planning, and using money managers.
Published June 15, 2015.