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Q

In your article “Hidden Gems in the Muni Market”, you state that a premium bond will produce about 50 basis points more yield than a comparable par bond maturing in the same year. However, as I see it, and what you don’t say, is that the 50 extra basis points comes from the premium that was paid in that, when the bond is called (at par or for less than the premium paid) or matures, the premium disappears or dissipates.  In other words, I am merely trading some return of capital for more current income.  It’s like taking the premium from the right hand and putting it in the left hand and calling it “additional yield.” Please convince me that I am making money by collecting less than I paid when I sell a bond or when it is called or matures at 100 when I paid, say, 105. As I see it, I am merely increasing my own current income with my own money taken from (by reducing) the premium part of the price that I paid for the bond.  Is that why, as I understand it, the IRS does not allow a capital loss (of the lessened premium) to be deducted on my income tax because the so-called “loss” is really transformed into “current income” and, therefore, merely changes its nomenclature – not its value?

A

James A. Klotz responds:

Without getting too technical, the case for premium bonds is made by comparing yields. Bond yield calculations are based on each and every dollar invested (including premium dollars), and take into consideration that bonds mature at 100.00, regardless of purchase price.

This means that the “additional” yield truly is additional. If it were only a transfer from one hand to the other, as you suggest, then the yields would be identical when comparing a premium bond to a comparable-quality par bond.

You are correct that premium bonds produce more current income. This additional cash flow, however, is just another benefit of owning bonds with higher coupon rates, which is the reason they trade above par in the first place.

The IRS does not allow capital loss treatment on premium bonds because the fact that they mature at par is inherent in the contract and does not represent a loss from economic risk.

In the bond market, yields determine price. The most compelling reason that premium bonds must provide more yield is, if they didn’t, no one would buy them.

We have always recommended taking advantage of premium bonds simply because most investors avoid them. As with any product, supply and demand factors dictate price, and in this case, yield.