Municipal Bond Forum
Advantages of premium bonds
Q
When I look for munis maturing in four or five years, the yield to maturity these days for AA or better is around 3.4% to 3.5%. However, I frequently see a YTM of 3.6% to 3.7%, where the only apparent difference from the surrounding bonds is that the higher yielding bond is actually a longer term bond that is pre-refunded (sometimes to 101 or 102, for example) to the earlier date four or five years from now. There are plenty of examples of this. Why should the market assign a higher yield to a pre-refunded bond with exactly the same rating as the bonds around it? I buy these pre-refunds all the time, but have never understood why they are the bargains they appear to be. Am I missing something?
A
James A. Klotz responds:
Your observation is not only correct, but can be taken a step further.
Since pre-refunded bonds are typically escrowed in U.S. Treasuries, they are of higher credit quality than any of the other AAA bonds surrounding them.
The yield anomaly you describe is really a function of merchandising rather than bond fundamentals.
Individual investors are too often averse to buying bonds which trade above 100.00. Pre-refunded bonds, by virtue of their larger coupons, produce higher dollar prices (premiums). Bond dealers must offer these bonds with higher yields simply to be able to sell them.
You, however, understand that the only way to determine the value of your bond investment is yield, regardless of the dollar price, and furthermore, that every dollar invested (including premium dollars) is working at the stated yields.
As a reader of our Bond Forum, you are aware that we always have, and continue to, recommend premium bonds to our clients precisely for this yield advantage.
Start here.
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