Profit from Your Premium Bonds

When investors see opportunity, we believe they should actively reposition their municipal bond portfolios to take advantage. Often, this requires selling some existing holdings. Today, investors are asking us: Why do you recommend I sell my long-term bonds? They’re yielding 5%. Won’t selling them reduce my potential returns?

These are great questions, and they’re ones we consider in our analyses. Right now we find that many investors own long-term callable bonds that will likely lose significant value when interest rates eventually rise. Our research indicates that there is an opportunity to reduce interest-rate risk and earn similar potential returns by employing active management.

Today, interest rates are near historic lows. That means many investors’ municipal bond portfolios are loaded with bonds worth more than their purchase price because they were bought when yields were higher than they are today.

When the price of a bond is more than its value at maturity (also known as par value), the bond is known as a “premium” bond. Bonds can be sold for more or less than their par values because of changing interest rates.

For example, an airport revenue bond issued only 2½ years ago at $98.5 with a 5% coupon is priced at $108.4 today, and has a yield of 3.7%. This premium bond is expected to pay $100 (par value) upon maturity in 2040.

What makes these airport bonds challenging to value is that they are also callable in 2020. In fact, most long-term municipal bonds are callable. When interest rates descend, long-term callable bonds rally like intermediate-term bonds—because they are priced to their call dates.

Conversely, if interest rates take flight, long-term callable bond values are likely to fall sharply as they begin to price to their long maturity dates.

In this way, long-term premium bonds that are subject to call have the upside of an intermediate bond, but the downside of a long-term bond. This asymmetry of potential returns is most clearly seen in extreme interest-rate movements, as explained in a previous post.

But before that maturity or call date, an investor has the opportunity to sell his long-term bond and pocket a profit.

If an investor takes no action, however, we know how the story ends. He will only be paid par at the maturity or call date—not the higher value. Active managers seek to take these profits and reinvest smartly.

In our view, a smart reinvestment today is in intermediate-term bonds, which offer expected total returns similar to those of long-term callable bonds when you consider both yield and price return from roll.

Roll is the value investors receive as bonds mature and "roll" down the yield curve. As a bond's yield declines with the passage of time, its price rises due to the inverse relationship between yield and price.

Roll for intermediate-maturity bonds is worth 1.7% today. Together with yield, the expected return of an intermediate bond is 3.7%—essentially the same as the yield of a long-term callable bond. Furthermore, in selling the long-term bond and reinvesting the proceeds in an intermediate-term bond, the investor has reduced his interest-rate risk.

Investors want consistent income and stability from their bond portfolios. By actively redeploying some long-term municipal bonds and navigating to a more attractive part of the yield curve, we believe investors may be able to achieve similar returns and increase the stability of their portfolio.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

R. B. Davidson III

Director—Municipal Bond Management
R. B. Davidson III joined Bernstein as Director of Municipal Bonds in 1992 and retained that responsibility after Bernstein’s and Alliance Capital’s fixed-income departments were combined. He is Chairman of the Tax-Exempt Fixed Income Investment Policy Group and a member of the Taxable Fixed Income Investment Policy Group. Davidson also serves on the partnership committee at AllianceBernstein as well as on the Investment Advisory Group to the Municipal Securities Rulemaking Board. Before joining Bernstein, he was vice president and head of municipal strategies at J.P. Morgan Securities and an associate economist at Lehman Brothers. He is the author of “The Value of Tax Management for Bond Portfolios,” published in T he Journal of Private Portfolio Management, Spring 1999; “Maximizing Expected After-Tax Returns,” published by Probus in 1994 in the Handbook of Municipal Bonds; and “Analyzing Quality Spreads,” published in The Municipal Finance Journal in 1991. Davidson was named to the Institutional Investor All-America Research Team in 1992. He earned a BA from Wesleyan University in 1983 and an MBA from the New York University Stern School of Business in 1991. Location: New York

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