Municipal Bond Forum
Too quick to judge merits of premium muni bonds
Q
I live in a retirement community where the chief financial officer is a volunteer and not educated in investments. We have a $2 million bond portfolio that she manages. She buys all five-year, high yield (4.00% to 5.00% in today’s 1.00% market) munis with stiff premiums. A recent purchase was a $50,000 par value 4.90% California muni with a five-year maturity (we live in CA) for which she paid over $58,000. The whole portfolio is like that. Please explain why she shouldn’t buy premium bonds; she won’t listen to me. Or call me crazy and tell me it’s OK to rack up $80,000 in premiums in this portfolio.
A
James A. Klotz responds:
Try not to pass judgment too quickly regarding premium bonds.
Actually, the dollar price is not usually an important factor when assessing the value of a bond.
Yield is the true indication of a bond’s value and often premium bonds will provide more yield to maturity as well as yield to the call date than comparable quality par bonds.
Keep in mind, all invested dollars are working at least at the worst case yield, including the premium dollars.
The reason bonds trading above par invariably yield more than par bonds is that investors are often averse to paying a premium as they inappropriately view the premium as a penalty and dealers must price them more cheaply (higher yield).
Where we might quarrel with your financial advisor is the short-term nature of the bonds she selects. We typically suggest longer-term bonds to maximize tax-free income. However, we would withhold judgment unless we were aware of any transactional or short-term cash requirements of the community.
We discuss premium bonds frequently and have written many times on the subject. Here’s one article you may find useful: “Premium Muni Bonds: The Best Play for Today”
Start here.
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