Municipal Bond Rates Are Not Important
Many bond investors looking for great bonds to buy look at the bond interest rates. Municipal bonds are no exception. People looking to invest in municipal bonds usually consider municipal bond rates first. However, most of the time municipal bond rates are not as important as one might think. There are many other factors that are far more important and should be considered before considering municipal bond rates.
Municipal bond rates are coupon rates of the municipal bond. They are the rates that the issuer set at the time of the issue how much they will pay investors for the money borrowed. When a municipal bond issuer issues a bond, the issuer works with the underwriters to come up with the appropriate interest rates, the municipal bond rates, to satisfy the issuer’s financial needs taking into account the market demand and supply. The municipal bond rates stay the same throughout the life of the bond.
It should be common sense that when a bond carries higher risk, investors should be paid more for buying it. For example, when a bond has a long shelf life or maturity date such as 10 years, the investor should be paid more for buying that bond than buying a bond that only has a shelf life of 1 year. However, municipal bond rates do not always change with maturities. Municipal bonds that mature in 10 years time can have the same municipal bond rates as bonds that mature in just one year.
When considering what bonds to buy, it is not adequate to consider just the municipal bond rates. In fact, some investors do not look at municipal bond rates at all. These investors prefer to consider the yields of municipal bonds because the yield takes into account many other important factors such as time to maturity and price of the bond.
There is more than one type of yield for municipal bonds. Different types of yields can be used to compare municipal bonds. While municipal bond rates cannot be used to compare municipal bonds, municipal bond yields can. Sometimes, municipal bonds with higher rates have also higher yields but not always. The price of the bond as well as time to maturity are can be very important factors to consider.
Municipal bonds can be sold or bought at premium, at par or at discount. It is no good buying municipal bonds with very high interest rates if you have to pay a lot for them. For example, which is better, a $10 investment that pays you $1 for 10 days and also $10 at the end or a $30 investment that pays you $1 for 10 days and only $10 in at the end? Of course the first because you invested $10 and get $20 back whereas in the latter case, you invest $30 and only get $20 back which means you just lost $10 in that investment.
Also, the longer the time to maturity, the higher the municipal bond rates should be. For example, consider the following investments. For a $10 investment you will get your money back plus $1 a day for the 5 years or for the same investment you will get $1 a day for the next 10 days. In the latter case, you know you will get your money back soon plus $10 more whereas in 5 years time things could have changed tremendously. There may be other better investments such as $2 a day interest which you cannot participate in because you already lock in your money.
In conclusion, higher municipal bond rates do not always mean better investments. It is better to consider the bond yield rather than its coupon or interest rates. This is especially true when an investor is investing long term. Higher yield is needed to compensate the investor for taking on more risk.
