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Considering the basic rule that suggests investors should "buy low and sell high," some investors may be concerned about the multitude of premium bonds in the market or in their portfolios, given that most of these securities will eventually be redeemed at par.1
Under current conditions, it might actually be difficult to find many bonds that are not trading at a premium. Yet, it is important to recognize why these securities have traded above par and that holding these bonds may provide a portfolio with multiple benefits—rather than anticipated losses.
The prevalence of premium bonds has been a function of the environment of historically low interest rates that is often described as "yield starved." Thus, securities offering yields that are above those in the broader market can create investor demand and lift the securities' prices above par, which is where they will eventually be called or mature. The prospects of at par redemption may lead to the inaccurate assumption that the premium would be lost over the remaining life of the bond, thus generating a loss for the investor.
A more accurate indication of a bond's potential return would be the yield to maturity, or yield to call,2 which properly captures the return on the investment, including the amortization of the premium until the issue is redeemed.
For example, if the prevailing market rate on 10-year bonds was 4.00%, investors would be willing to pay more for a bond with a 5.25% coupon. When the premium is factored in, this bond would have a yield to maturity3 of 4.00%, in line with the prevailing market rates. (See Table 1.) This yield to maturity factors in the bond's current income4 and its price amortization, and indicates an annual return of 4.00%, rather than a loss due to the redemption at par.
Even though premium bonds often yield more than comparable quality bonds trading at lower prices, some investors may shun premium bonds based on the misguided perception that there is an implicit loss awaiting them at maturity. For professional investors, this perception may offer an opportunity to improve portfolio returns relative to comparable bonds at lower prices and slightly lower yields without increasing credit risk or interest-rate risk.
Concerned about Rising Rates?
The prolonged decline in interest rates to their current, historically low range leaves less room for them to decline further. This prospect has many investors concerned that interest rates may be due for a notable increase if economic growth and inflation were to accelerate in the near future.
While a potential increase in interest rates could negatively affect many fixed-income securities, premium bonds, in this scenario, could experience less volatility. This is because the higher coupons on premium bonds can provide a higher level of current income that may be reinvested in newly issued securities with higher interest rates.
When compared with securities with lower coupons, the benefit of premium bonds' higher income potential is reflected in a shorter duration, thus indicating less interest-rate risk. The effect that coupon rates can have on an asset's performance is demonstrated in Table 1, which depicts an extreme scenario of how an immediate 100 basis-point increase in interest rates can affect two different bonds. (As an aside, when the time comes to start removing some of the Federal Reserve's monetary policy accommodation, it is likely do so at a much more gradual pace than portrayed in Table 1.)
Source: Lord Abbett.
This hypothetical example is for illustrative purposes only. The value of an investment in debt securities will fluctuate in response to market movements. When interest rates rise, the prices of debt securities are likely to decline, and when rates fall, prices tend to rise.
Opportunities from Active Management
The concern among some investors about the prevalence of premium bonds may be based on an assumption that the securities would be bought and held to maturity. Premium bonds not only may provide positive returns under that assumption (as previously described) but also they can provide numerous opportunities for actively managed strategies. After all, these strategies might identify times when it is better to sell a premium bond and reinvest the proceeds rather than letting the security mature and taking the chance on what conditions may hold at that point.
The opportunities to sell premium bonds often occur as longer-term bonds roll down the yield curve. This describes the process where bonds progress toward their maturity dates. And as they do so, their higher yields create investor demand and their prices rise.
Therefore, in an environment of steady interest rates, a premium may gradually accumulate on a long-term bond over time. An active manager could weigh the potential return on the bonds based on the yield to maturity or attempt to capture the premium by selling the bond before the premium erodes. (See Figure 1.) An actively managed portfolio also could simplify the tax considerations that individual investors might otherwise face from buying individual bonds on their own.
A theoretical scenario depicting how active strategies might profit from bond premiums
Source: Lord Abbett.
For illustrative purposes only.
The attributes of premium bonds underscores the numerous factors that can affect performance in the fixed-income markets. While the saying "buy low, sell high" still has a place in some investing scenarios, a disciplined approach to the fixed-income markets involves a more detailed analysis that not only accounts for the price of a bond but that can also include yield to maturity, coupon, call protection, and liquidity.
A Note about Risk: The value of investments in debt securities will fluctuate in response to market movements. When interest rates rise, the prices of debt securities are likely to decline, and when interest rates fall, the prices of debt securities tend to rise. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. No investing strategy can overcome all market volatility or guarantee future results.
A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.