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Q

I bought long-term muni bonds last year with 5% to 6% coupons at below par value. They have returned regular income and appreciated in value. In six months, I receive a multimillion-dollar lump sum and want to purchase munis for income. If current prices don’t change, then I would be buying bonds at a premium and building in a long-term loss. Should I buy anyway for the income or look for high-quality bonds that are nearer their par value?

A

James A. Klotz responds:

It is important to remember that buying a bond at a “premium” is not a “penalty.” It simply reflects the appropriate yield for the current interest rate environment.

In fact, bonds trading above 100.00 typically offer the best values in the market. Ironically, this is the case because they are often misunderstood by individual investors who resist buying premium bonds because they perceive them as being more expensive than par bonds, misinterpreting the relationship between “dollar price” and “yield.”

After quality considerations, yields are the key factors when evaluating the price of any bond.  The dollar price is merely a mathematical function of the yield. Every dollar invested in a premium bond (including premium dollars) is working at the stated yields.

Premium bonds invariably carry a higher yield-to-maturity than par bonds of comparable quality, and if called, they will yield more to that call date than any par bond you could have purchased maturing in that year.

For more on premium bonds, click on the following article: “Hidden Gems in the Muni Market“.