There are more investors today than ever before that prefer to hold onto to their cash instead of buying bonds. One reason for this is because they are worried that the interest rates may increase and the bond values may depress. A bond premium is not immune to this, and it is likely that the price of this type of bond will fall if the rates begin to increase. However, they may be able to provide a way to capture increased yields that are offered by income securities that are fixed, and also offer some level of protection against the risk of interest rates.
While some investors are often in favor of a bond premium, they are not as attractive to other types of investors like retail investors. For many individuals, these types of bonds offer benefits that can outweigh the additional effort needed to evaluate them.
Why Should You Pay A Premium?
To truly appreciate the defensive role these types of bonds can play, it is critical to understand the basic principles that are used to price these bonds. When you purchase a bond, either as one that is a new issue or one that is secondary, it can be priced at the face value of the bond. This price will be at a discount to the face value of the bond or at the premium of the face value.
Paying a premium for bonds means that you will have to make larger investments. However, the question remains. Why would an investor pay more money for the exact same yield? The answer is simply because premium bonds generally have higher coupons. In other words, these types of bonds allow a trade off that is straightforward. You can pay more in the beginning for much larger interest payments.
This is a critical concern when considering investing in bonds. It is a measure of how sensitive a bond is to the changes that occur with interest rates. The best use of duration is that investors have the opportunity to compare how sensitive two bonds are to interest rate changes. Therefore, if a bond has a duration of four years, the interest rate sensitivity of that bond would be twice that of a bond with a duration of two years.
Staying On Defense
Premium bonds have shorter durations, and this means that they hold onto their values longer than par bonds or discount bonds. This is true when the other features of the bonds are the same, while interest rates increase.
These bonds also have larger cash flows that will allow you to reinvest into new bonds that will allow you to capture the increase of the interest rate. When the environment is partial to higher interest rates, the more cash flow that is received with premium bonds give investors the chance to reinvest at a much higher interest rate.
When you are trying to manage your investments, it is important to stay vigilant of all of the risks even if you decide to invest in a bond premium. It does not matter if you want to build a portfolio of bonds, of if you want to invest in diversified funds, consider securities in a range of sectors.