Should I Invest in Municipal Bonds During Rate Hikes?
Municipal bonds, or “munis,” are popular investments for a few reasons. Most notably, as a government bond, they can be the closest thing to a safe asset that the market offers. And, investors typically pay no federal taxes on the income that these bonds generate, creating an effective boost to their otherwise relatively low rate of return. Ordinarily, this can be a very stable section of the market. But during Federal Reserve interest rate hikes, bond payments can rise and prices fall. This can result in higher yields and lower returns overall, although municipal bonds don’t always follow this rule. Here’s how it works.
How Bond Yields and Returns Work
All bonds, whether government or corporate, are debt instruments that have three essential elements: par value, market price and coupon rate.
The note’s par value (or “face value”) is the amount someone originally paid for this bond, and the amount that the issuer will repay to the owner of the bond once it matures. Market price (or “current price”) is the amount that someone is willing to pay to buy the bond today. Coupon rate is the interest that the issuer pays to whoever owns the bond at any given time.
Together, these three elements inform an investor’s yield and their return on the investment.
Yield is based on the relationship between a bond’s market price and its coupon value. As an investor, your yield is how much you make from the investment relative to how much you paid for it. The higher the coupon rate compared with your market price, the better your yield.
It’s important to note that, since market prices change, an investor’s yield and a bond’s coupon rate won’t always be the same. The coupon rate is how much interest the bond pays compared with its original, face value. A given investor’s yield is how much interest the bond pays compared with how much that investor paid for the bond. These figures will usually differ.
Return is based on the relationship between past and future market prices. As an investor, your return is the difference between how much you paid for the bond and how much you sell the bond for. If you hold the bond until maturity, return is the difference between the bond’s market price and its par value.
For example, consider a bond with the following characteristics:
Par Value: $1,000
Market Price: $900
Coupon Rate: 5% Annually
This is a bond which the company originally sold for $1,000. At the bond’s maturity, the company will pay that $1,000 back to its owner at the time. Right now, people in the market are willing to pay $900 to own this bond. The company that issued the bond pays $50 per year to the bond’s owner, since this is 5% of the asset’s par value.
If you bought this bond, you would pay $900 up front and make $50 per year. This gives you a yield of 5.5% annually ($900 market value / $50 interest payments).
Your yield is different from the interest rate because the bond is selling below its par value, making the bond’s interest payments more valuable relative to what you paid for it.
Your return would depend on market prices. But you are guaranteed a minimum return of $100 if you hold the bond until maturity ($1,000 par value – $900 market value that you paid).
Rate Hikes Increase Yields, Decrease Returns
When it comes to the bond market in general, Federal Reserve rate hikes tend to have two main effects:
Yields, based on interest payments, go up
Returns, based on market price, go down
Once a bond is issued its coupon rate never changes, but market interest rates do. This means that newly issued bonds tend to have higher interest rates than previously issued ones. (Like most debt-based assets, bond interest rates are heavily influenced by the Federal Reserve’s interest rate.)
This causes investors to start expecting better yields, since new bonds on the market pay more money relative to their face value than existing assets do. This has the effect of pushing market prices for existing bonds down.
For example, say that ABC Bond has a market price of $1,000 and interest payments of $50 per year. This gives it a yield of 5%.
Now, the Federal Reserve raises rates. New bonds come on the market with coupon rates of 10%, meaning that new $1,000 bonds pay $100 per year in interest. This makes ABC Bond much less valuable to investors at its face value. They would rather get the 10% return than the 5% return. So investors who hold the existing ABC Bond start asking $500 for that bond. Relative to the bond’s $50 per year interest payments, that pushes the ABC Bond back to an effective 10% yield and makes it competitive on the market again.
The Federal Reserve’s rate hike has increased the yield for bond investors, who can now make $50 per year from a $500 investment rather than a $1,000 investment. It has also decreased the return for bond investors, who now have to accept $500 if they want to sell the bond that they paid $1,000 for. Finally, it will likely influence liquidity in the secondary bond market. Sellers become more likely to hold their position rather than take a loss, while buyers may reduce their activity until rate hikes do push those prices down.
Municipal Investors May Not Need to Worry
This is a well-established behavior in the bond market. When the Federal Reserve raises its benchmark interest rate you can expect better yields for income investors and lower returns for capital gains investors.
The result is that imminent rate hikes are generally a good reason to wait before investing in bonds, because prices will likely soon fall. Stabilizing, or even potentially falling, rates are a good reason to start buying, because prices may soon rise.
However, municipal bonds don’t always seem to follow this pattern. As Goldman Sachs wrote in one market analysis, “recent history suggests Fed rate hikes may not be such bad news for muni portfolios… [A] look back at the last four Fed tightening cycles reveals that muni yields were not as sensitive to higher rates as investors might have thought and generally produced positive returns.”
Short-term municipal bonds seem more sensitive to the Federal Funds Rate. But overall during the last four Federal Reserve rate hikes, municipal bond yields changed far less than corporate debt or the overall rate changes. In most cases average yields changed by less than half the rate of prevailing interest rates. Additionally, returns on both municipal and corporate bonds remained mostly positive. In fact, municipal bond returns were significantly higher than corporate bonds during the 2006 and 2018 rate hikes.
This does not mean that investors should necessarily flood into this sector of the market. Past performance is no guarantee of future results, after all. Instead this likely means that for municipal bond investors, Federal Reserve rate hikes may not be a reason in and of themselves to change your investment strategy.
When the Federal Reserve raises interest rates, bond yields tend to go up while returns tend to decline. While this trend typically holds true in the market, average yields for municipal bond investors during recent hikes have changed by less than half the rate of prevailing interest rates.
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