Premium bonds have been the choice of investors now for many years but is that preference beginning to shift in favor of discount bonds? Discount bonds are appearing in bond structures with increasing regularity in recent months. We lawyers leave that question for the underwriters and financial advisors as interest rates turn upward. However, we need to be prepared for the shift in bond yield calculations that accompany a re-emergence of discount bonds.

When the current bond yield calculation regulations of Reg. 1.148-4 were first published in the early 1990’s, discount bonds were the preference of the day and tax lawyers became very familiar with the special yield calculation adjustment for discount term bonds. Later, as interest rates dropped to previously unimaginable levels, discounts disappeared and were replaced with sky-high premiums. Those premiums resulted in the application of the bond yield adjustment triggered by a threshold that we can all recite in our sleep: the adjustment applies to bonds that are subject to optional redemption before maturity and have an initial offering price that exceeds their stated redemption price at maturity by more than one fourth of 1% multiplied by the product of their stated redemption price at maturity and the number of complete years to their first optional redemption date. When premium bonds trigger this rule, they must be treated for issue yield calculation as though called on the date that results in the lowest yield on those premium bonds. (Recall that this rule was the subject of a recent technical change to the regulations, substituting the minimization of yield on the particular bonds for the prior minimization of yield on the issue, as described in our post of July 22, 2016).

The theory underlying this yield adjustment is that, provided market yields do not rise dramatically by the call date, the issuer will likely call those bonds as early as possible (assuming a reasonable or no call premium) and thereby minimize the yield on those bonds. This occurs because the early call shortens the amortization period of the premium thus maximizing the downward effect of the premium on yield.

If the market does in fact move back to discount bonds, and in particular discount term bonds, our focus will shift (or at least expand) to the special yield adjustment for those bonds. That adjustment applies to substantially identical bonds that are subject to mandatory early redemption (i.e., term bonds) and that are issued at a percentage discount greater than one-fourth of 1% multiplied by the weighted average maturity of the bonds (with the WAM computed taking into account mandatory early redemptions). For any bonds that are subject to this adjustment, mandatory redemptions are treated as occurring at present value rather than at stated principal amount. Present value is calculated using as the discount rate the yield to the final maturity date of the term bond. In other words, under this rule, mandatory redemptions are treated as occurring at accreted value.

The theory underlying this adjustment is that if market interest rates remain constant, the issuer can be expected to purchase bonds on the market at a discount to satisfy the mandatory early redemption requirements rather than redeeming the bonds at their par amount. With no change in market yields, the bonds should be available on the market at their accreted value.

So be prepared for this yield calculation adjustment for discount term bonds – as my grandmother always said, if you wait long enough, everything comes back into vogue.