Municipal bonds, or “munis,” are popular investments for several reasons. Most notably, as government bonds, they have the potential to be the closest safe-haven asset the market offers. Investors also typically pay no federal tax on the income these bonds generate, effectively driving a relatively low rate of return. Usually this can be a very stable section of the market. But when the Federal Reserve raises rates, bond payments could increase and prices could fall. This may result in higher yields and lower returns overall, although municipal bonds don’t always follow this rule. Here’s how it works:
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Bond Yield and Return Mechanism
All bonds, whether government bonds or corporate bonds, are debt instruments with three key components: face value, market price and coupon rate.
The face value (or “face value”) of a note is the amount someone originally paid for this bond, and the amount that the issuer repays to its owner when the bond matures. The market price (or “current price”) is the amount someone would be willing to pay to buy a bond today. The coupon rate is the interest paid by the issuer to the holders of the bond at any given time.
Together, these three factors determine an investor’s yield and return on investment.
Yield is based on the relationship between the bond’s market price and coupon value. Your yield as an investor is the amount you get from your investment compared to the amount you paid for it. The higher the coupon rate compared to the market price, the higher the yield.
It is important to note that an investor’s yield and a bond’s coupon rate are not always the same because market prices change. The coupon rate is the amount of interest a bond pays compared to its original face value. Yield for a particular investor is the amount of interest a bond pays compared to what that investor paid for the bond. These numbers are usually different.
Returns are based on the relationship between past and future market prices. Your return as an investor is the difference between the amount you paid for the bond and the amount you sold the bond. If you hold a bond to maturity, your return is the difference between the bond’s market price and its face value.
Example: bond yields and returns
For example, consider a join with the following characteristics:
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Face Value: $1,000
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Market price: $900
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Coupon rate: 5% annually
This is the bond the company originally sold for $1,000. At maturity of the bond, the company will return that $1,000 to the holder at that time. People in the market are now willing to pay $900 to own this bond. The company that issued the bond pays the bond owner $50 a year because it is his 5% of the par value of the asset.
If you buy this bond, you pay $900 upfront and earn $50 a year. This yields an annual yield of 5.5% ($900 market price / $50 interest payment).
Yields differ from interest rates because bonds are sold below their par value. Interest payments on bonds are worth more than the amount paid.
Your return will depend on the market price. However, holding the bond to maturity guarantees a minimum return of $100 ($1,000 face value – $900 market price paid).
Rate hikes raise yields and lower returns
When it comes to the bond market in general, Fed rate hikes tend to have two main effects.
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Increased yield based on interest payments
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Market price-based rate of return will decline
When a bond is issued, the coupon rate does not change, but the market interest rate does. This means that newly issued bonds tend to have higher interest rates than previously issued bonds. (Like most debt-based assets, bond interest rates are heavily influenced by Federal Reserve interest rates.)
This makes investors start expecting better yields. This is because new bonds on the market pay more money relative to face value than existing assets. This has the effect of pushing down the market price of existing bonds.
For example, ABC Bond has a market value of $1,000 and an annual interest payment of $50. This gives a yield of 5%.
Now the Federal Reserve is raising interest rates. The new bond hits the market with a coupon rate of 10%. So a new $1,000 bond pays $100 in interest per year. This makes his ABC Bonds much less face value for investors. They’d rather him get a 10% return than he would a 5% return. Therefore, an investor holding his existing ABC bond begins to demand his $500 on that bond. Compared to the bond’s annual interest rate of $50, the ABC bond returns to an effective yield of 10%, making it competitive again in the market.
Federal Reserve interest rate hikes have boosted yields for bond investors, who can now earn $50 a year on a $500 investment instead of a $1,000 investment. It also reduced profits for bond investors who had to accept $500 if they wanted to sell a bond that paid $1,000. Finally, it may affect the liquidity of secondary bond markets. Sellers are more likely to hold their positions than suffer losses, while buyers may curtail activity until a rate hike drives prices down.
Municipal investors may not have to worry
This is established behavior in the bond market. If the Federal Reserve raises its benchmark interest rate, we can expect better yields for income investors and lower returns for capital gains investors.
As a result, an imminent rate hike is generally a good reason not to invest in bonds. Because prices are likely to fall soon. Stable or possibly declining interest rates are a good reason to start buying as prices could rise soon.
However, municipal bonds do not always follow this pattern. As Goldman Sachs wrote in one market analysis, “Recent history suggests that Fed rate hikes may not be such bad news for municipal bond portfolios… [A] A look back at the last four Fed tightening cycles reveals that yields on municipal bonds were generally less sensitive to rate rises than investors thought and generally produced positive returns. ”
Short-term municipal bonds appear to be more sensitive to the federal funds rate. But over the last four Fed rate hikes, municipal bond yields have changed much less than corporate bonds and overall interest rates. In most cases, average yields changed by less than half of prevailing interest rates. Moreover, returns on both municipal and corporate bonds remained largely positive. In fact, during the 2006 and 2018 rate hikes, municipal bond returns significantly outperformed corporate bonds.
This does not mean that investors should rush into this sector of the market. After all, past performance is no guarantee of future results. In turn, this means that for municipal bond investors, a Fed rate hike in itself may not be a reason to change investment strategy.
Conclusion
When the Federal Reserve raises interest rates, bond yields tend to rise and returns tend to fall. While this trend is usually the case in the market, average yields for municipal bond investors during recent rate hikes have changed by less than half of prevailing rates.
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