Municipal Bond Interest Rates - How Do These Work?

We all know that municipal bonds are one of the few safest investments in the market because of the backing of the local and state governments that issued these debt instruments. But before investing in these debt instruments, it is always a good idea to know a few important things about municipal bond interest rates. Keep in mind that your actual profit from buying and selling or buying and trading bonds of any kind mainly comes from the interest amount earned on the instruments.

Municipal Bond Interest Rates - Price-Yield Correlation

The first step is to know the price-yield correlation. This is important in predicting municipal bond interest rates because when these rates fall, then the bond prices will rise. Conversely, when the interest rates rise, then the bond prices will fall.

Let's take an example. A $1,000 bond carries an interest rate of 5% per annum, which means that it will pay out a $50 interest amount divided into two $25 semi-annual payments. Supposing that the interest rates on the municipal bond rise to 7%, we can safely assume the following things:

• The bondholder will offload the bond at a discount (a value less than the par value stated on the bond certificate). After all, the current prospective buyers can enjoy a $70 interest payment per year elsewhere. This is with the assumption that the bonds have similar terms for credit risk and maturity period.
• The bondholder will experience pressure to sell the bonds. They now have the opportunity to make an additional 2% per year if they do so.

Thus, if you can predict the movements of the municipal bond interest rates, then you can make a better decision to either buy or sell bonds.

Municipal Bond Interest Rates - Causes of Interest Rate Movements

This leads us to the next question: What causes the interest rates on municipal bonds to move either upward or downward during the course of its maturity? There are many factors, of course, but let's discuss a few of the most important for reasons of space limitations.

First, the US Treasury securities including the Treasury bonds, notes and bills have significant impact on the general rates for all types of bonds. Think of the municipal bond interest rates as indexed on the interest rates for the US Treasury marketable securities.

In turn, these general bond rates are influenced by a wide variety of economic indicators both in and out of the country. These indicators include the Gross Domestic Product (GDP), the Consumer Price Index (CPI) and the Producer Price Index (PPI), among others. Since these indicators are predictable to a certain significant degree, it is then possible to also predict the movement of interest rates.

Second, the rates for unemployment, housing and other economic indicators not mentioned above also affect the interest rates. Experts are still debating on the extent of influence that each factor has on the bond interest rate so we best left it to them.

Suffice it to say that municipal bond interest rates may not be as predictable as we like them to be but we can make good forecasts based on reliable data and past experience. This is as good as it gets in investments, indeed.