How interest rates affect municipal bond prices

Municipal bonds (otherwise known as “munis”) are government-issued debt securities that are used to fund day-to-day operating expenses or to fund large-scale capital projects like building schools and repairing highways and bridges. When an investor purchases a municipal bond, they loan money to the government in exchange for a series of interest payments to be paid on a regular schedule and a return of their original investment once the bond term expires. Bonds can be short term, which are typically one to three years, or long term, which can have maturities of over 10 years.

There are two types of commonly issued municipal bonds: a general obligation bond and a revenue bond.

• General obligation bond: A general obligation bond is an unsecured bond issued by a state, city or county. "Unsecured" means they are not backed by hard assets. Rather, they are backed by the “full faith and credit” of the bond issuer. This means that the government that issues the bond can tax residents of that state, county or municipality to raise the revenue to pay back the bondholders.
• Revenue bond: A revenue bond is backed by the revenue that will be created by the specific project. Toll roads and lease fees are two common types of revenue streams that would be used to pay bondholders. However, investors will face higher risks because many revenue bonds are "non-recourse" bonds, which mean that if the revenue source were to dry up, so would the funding source, leaving bondholders with no recourse to claim their interest payments or principal.

A variation on these bonds occurs when a government entity issues a bond on behalf of a third party, such as a hospital or non-profit university. In this case, the third party (known as the "conduit" borrower) repays the issuer of the bond, who in turn pays the interest and principal to the bondholders. Like a revenue bond, however, there is a risk of default if the conduit borrower does not make payments to the issuing party. In most cases, the issuer is not required to repay the bondholders.

Government entities are nonprofit operations. Unlike a corporate bond that allows investors to evaluate a company’s balance sheet for clues to their ability to pay bond obligations, no such structure really exists for municipalities. If tax revenues decline, the issuer may not have the necessary funds to compensate the bondholder. Municipal bonds have credit ratings just like other bonds but a high rating does not mean that the bondholder will not default. However, it is fair to say this risk is not necessarily greater or worse than the risk presented by corporate bonds.

Aside from that default risk, however, there are other subtle risks to owning municipal bonds, including the following:

• Call risk: It is possible for the bond issuer to "call" a bond, which means repaying the buyer the principal and all unpaid interest prior to the maturity date. This is typically done when interest rates fall. The bond issuer seeks to take advantage of lower long-term borrowing costs through lower interest rates. This is similar to a homeowner who refinances a mortgage to take advantage of lower interest rates. When interest rates are stable or projected to move higher, the call risk associated with these bonds is negligible.
• Interest rate risk: Municipal bonds carry a fixed-rate value, referred to as its “par” value. When the bond reaches maturity, the bondholder will be paid the par value, plus any interest. However, a bond’s market value will continue to move up and down with prevailing interest rates which can mean that the market value will be lower than the par value. Bond prices and interest rates move in opposite directions. When interest rates fall, the market price of a bond will rise. When interest rates rise, the market price of a bond will fall. If a bondholder holds a bond with a low fixed-rate value and interest rates move higher, an investor may lose money if they try to sell the bond before maturity because of its lower market value.
• Inflation risk: Inflation risk is similar to the interest rate risk since inflation generally results in higher interest rates, which lowers the market value of a bond. Another risk with inflation is that the purchasing power of the interest they receive will be reduced as inflation raises consumer prices.
• Liquidity risk: Many bondholders buy municipal bonds to hold them rather than to trade them. However, investors who may be inclined to sell a municipal bond may find the market for selling is not very active, which could result in an inability to sell the bond when they would like or for the price they desire.

The interest rate of a bond is set by two factors. The first is the credit rating of the bond issuer. This is similar to what consumers experience when they seek a bank loan. Just like a corporation, government entities have credit ratings. Those with a poor credit rating will have bonds that trade at a discount as prospective buyers assess the potential default risk with the price they pay for holding the bond. This should serve as a warning for investors that are tempted by the allure of a high yield. Bond investing is about security. If a municipal bond has a yield that seems too good to be true, it may indicate an underlying problem.

The other factor that determines the interest rate on a bond is the length of maturity. In general, the longer a bond issuer asks you to hold the bond before maturity, the more it will dictate a higher interest rate. However, this reflects normal market conditions with a yield curve that shows long-term rates as higher than short-term rates. In a case where the yield curve flattens or inverts, investors may see higher interest rates on short-term bonds.   

Just because a municipal bond is not issued by a public company does not mean there are not resources available to investors to determine the quality of the bond and the potential default risk involved with the bond. A free source of information regarding municipal bonds can be found at the Electronic Municipal Market Access (EMMA) website from the Municipal Securities Rulemaking Board. You can find disclosure documents which are similar to a company’s prospectus. You can also view historical and real-time transaction price data. However, the availability of recent price information depends on how actively a particular bond issue is traded.

Municipal bonds are one of the safest and least risky of all kinds of bonds. Municipal bonds do not tax the interest bondholders receive at the federal level and in many cases will not tax at a state or local level provided the bondholder resides in the state or municipality where the bond is issued. In return for this favorable tax treatment, however, bondholders typically receive a lower rate of return than they would receive with a corporate bond.

As with any other investment, do your due diligence before purchasing a municipal bond and avoid bonds that carry a yield that seems too good to be true. In many cases, that may point to underlying problems.