Understanding Municipal Bond Market Risk

Whether a bond pays the investor a fixed interest rate (also known as the coupon rate), which cannot be changed during the life of a bond, or a variable interest rate, the market price of a municipal bond will vary as market conditions change. If you sell your municipal bonds prior to maturity, you will receive the current market price, which may be more or less than the original price depending on prevailing interest rates at the time of sale. So, for example, a municipal bond issued with a 5.0% coupon will sell at a premium if interest rates at the time of sale are below 5.0%.  Consequently, it is important to understand that municipal bond prices fluctuate in response to changing interest rates: prices increase when interest rates decline, and prices decline when interest rates rise.

It’s easy to understand the reasons:

  • when interest rates fall, new issues come to market with lower yields than older securities, making the older securities worth more, hence the increase in price; and
  • when interest rates rise, new issues come to market with higher yields than older securities, making the older ones worth less; hence the decline in price.

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