5/23/13 UPDATE: This article has been adapted and re-published in the HFMA Strategic Financial Planning newsletter Summer 2013 issue.
- Premium bonds are sold at a premium over face value and pay an above-market coupon.
- If a callable premium bond is held to maturity, its yield will be higher than if it is refunded.
- Yield to call is the lowest yield: worst case scenario for investors, best case for borrowers.
- In a rising rate environment, yield to maturity may be a better way to compare premium bonds to other structures.
What Is a Premium Bond?
A premium bond is a bond which sells for more than its face value and pays a coupon above market. In today's markets, most premium bonds pay a 5.00% coupon to yield 4.00-4.50%, depending on credit quality and term. Premium bonds are attractive to some investors and can reduce the par amount of a bond issue, which helps minimize the impact of additional debt on leverage and other key ratios.
Why Do Investors Like Premium Bonds?
Retail investors prefer par or discount bonds, but institutional investors, who drive the markets for pricing, are attracted to premium bonds for several reasons. For starters, premium bonds are less sensitive to rising rates. Because their coupon is higher than market, investors get their money back faster. This comes in handy in a rising interest rate environment, because the principal can be reinvested at higher market rates sooner. Institutions also like the greater chance of avoiding the de minimis tax rule on capital gains when bonds end up trading at a discount, a common occurrence when rates rise. Last but not least, premium bonds can end up paying a higher yield than par or discount bonds. This also means they can be more costly to borrowers.
Premium Bonds Can End Up Costing More
The yield on premium bonds often ends up higher than advertised, which can come as a surprise to hospital financial executives. The root of the problem is an industry convention which is intended to put investors first. It is known as the Yield To Call ("YTC") convention, and it requires municipal professionals to calculate yield on callable premium bonds by assuming they are refunded on their first call date (usually 10 years).
The same convention dictates that the yield on par and discount bonds is calculated using Yield To Maturity ("YTM"), which assumes bonds are held… well, to maturity.
The convention was meant to represent the worst case scenario for investors. Indeed, they hold a bond paying an above-market coupon so if that bond gets called, they no longer receive the extra return. For borrowers however, YTC is a best case -- it can get worse from there. The longer the premium bond stays outstanding past first call date, the higher the final yield, since the borrower continues paying the high coupon. In recent years, nobody complained about having to use YTC. After all, a premium bond would start its life as a refunding candidate right out of the gate and would typically be refunded if rates stayed flat or declined, as they have for the last several years.
But what if rates rise instead? Then the opposite is true: a refunding is less likely, and YTC may underestimate the final yield. In a rising rate environment, as we may finally be facing today, YTM may be a more prudent approach for borrowers.
The Problem with Using YTC for Premium Bonds
Using YTC to evaluate premium bonds can understate yields if the bonds are held to maturity. Based on our review of 17 recent hospital bond issues that featured both premium and non-premium (par) bonds for the same maturity:
- The par bond YTM was 23 bps higher on average than the premium bond YTC
- When using YTM for both bonds, premium bonds paid on average 30 bps more than par bonds
- Using YTM instead of YTC added on average 50 bps to premium bonds.
Since official statements use the YTC convention, premium bonds always look to be paying a lower yield than par or discount bonds, when in fact, the opposite is true. In the example below, the hospital sold two 2039 term bonds: a premium bond at a 5% coupon to yield 3.58% (yield to call, indicated by an asterisk), and a par bond at 4% to yield 4% (yield to maturity). If the premium bond is never called, its yield to maturity becomes 4.26%, 26 bps more than the same bond sold at par, and a whopping 68 bps more than its "advertised" yield to call.
How To Evaluate Premium Bond Structures
What does this mean for hospitals considering issuing debt with premium bonds? Given the impact of optional redemption, they ought to start thinking of premium bond yields as belonging within a range, rather than a set value. If the bonds are called on first call date, the final yield will be YTC, aka the borrower's best case scenario. If not, the final yield will be higher, potentially all the way up to YTM. If a refunding is unlikely, a prudent approach is to use YTM instead of YTC.
When comparing pricing on various debt structures, some with premium bonds, some without, using YTM allows for a direct comparison. A good example is a public offering vs. a bank direct placement. A placement only involves par bonds and while it may look more expensive compared to a public offering with premium bonds, in reality, the placement yield may be lower if both structures are evaluated using YTM. Mixing the two yield formulas should be avoided unless there is a clear expectation premium bonds will be called on first call date.
In discussions with bond underwriters before and after day of pricing, the hospital will want to make sure the all-in true interest cost or “TIC” is comparable to other deals shown by bond underwriters. If YTC was used --as arbitrage regulations typically require-- the yield may be acceptable to the IRS for arbitrage rebate purposes, but it won't be directly comparable to other structures whose yields are calculated using YTM.
By recognizing that premium bonds are not as predictable as par bonds and that their final yield will depend on if and when they are called, hospitals will be in better position to develop meaningful comparisons between structural options and successfully minimize their cost of debt.
This material is intended for general information purposes only and does not constitute legal advice. For legal issues, readers should consult legal counsel. To discuss this article or municipal advisory services, email firstname.lastname@example.org or call 888-699-4830. HFA Partners, LLC is an Independent Registered Municipal Advisor registered with the Securities and Exchange Commission (SEC) and the Municipal Securities Rulemaking Board (MSRB) under the Dodd-Frank Act of 2010.
© 2009-2017 HFA Partners, LLC.