You’re taught early in bond investing that when interest rates bond, bond prices fall.  And when interest rates fall, bond prices rise.  So you’d think by this statement that if you owned bonds, you want interest rates to continue falling.  This is simply not true.  Before we delve into this, let’s cover some basics below (and you can also read our intro to muni’s here: Muni Bond Basics)


Bonds have three main components: price, coupon and maturity (leaving out credit rating on these examples).  Bonds are priced at either a discount to par (below 100), at par (100), or above par (above 100).  Par is the price that the bond will mature at and almost all of the muni bonds we have purchased for clients mature at 100.  A bond you bought January 1st this year that pays a 5% coupon and matures in 20 years may go through a similar path of price in the diagram below.  Over the next 20 years, the price of the bond might rise to $115, fall to $90 rise back to $110 and then fall back to $100 at maturity.  If you held  the bond until maturity, you would have received $5 per year for every bond that you owned for 20 years and lost $10 since you paid $110 and it matured at $100.  A buyer of a muni bond looks at its current yield (CY), yield to maturity (YTM) and yield to call (YTC).  We’ll focus on CY and YTM in these examples.  The CY is calculated by dividing the coupon over the price.  In the example below, the CY is 4.55% (5%/110).  YTM on the other hand assumes your reinvesting all of the coupon payments that you receive into new bonds with the same yield and amortizes the $10 premium you paid when you purchased it.  In the case of a bond that you purchased below $100, it would amortize the difference between par and the price paid as a gain.  In the example below, the YTM is 4.25%.

Unless you needed to sell the bond when it traded at $115, you never truly booked a profit.  Similarly, when the bond touched $90 (about 10 years in), you never actually booked a loss.  Your CY is booked the day you purchase the bond and the realized YTM will fluctuate depending on the future of interest rates over the life of the bond.


Potential Price Movement of a 5% Bond Over 20 Years



Not Taking Income Scenario:

Let’s assume a scenario where it makes sense to have a % of your assets in muni bonds even though you’re not using the income.  In this scenario, as an investor, I want to be in a rising rate environment, not a falling rate environment, even though the price of the bonds I own would temporarily be falling in value.  YTM assumes you’re reinvesting at the same rate that you purchased the bond.  In falling rate environment, your realized YTM would be lower than when the bond was purchased since you’re reinvesting at lower rates, not the same rates as when it was purchased.  In a rising rate environment, you’re reinvesting interest at higher rates therefore you increase your YTM over the life of the bond.  You deal with statement frustration during these times since you see the price of the bonds you own fall in price.  But the bond you purchased at $11o that goes to $115 will inevitably fall to $100 as it matures and all that premium will be lost.  The only way you retain that gain is if you sell it, but then you’re trading tax free income for a capital gain.  And then after the sale, you have to find another bond to purchase but most similar bonds will be priced around $115 range unless you shop downmarket and purchase a lower quality bond.  As long as the bonds you own still have solid credit ratings, it really doesn’t matter what the price is after you purchase it unless you plan on trading it.  Even though it’s frustrating, I would choose the path below after a bond is purchased  since my YTM would be much much higher than the 4.25% when I purchased it.  If the bond below had 10 years left to maturity and was priced at 70, it’s CY is 7.14% and YTM is over 9%.  I’d be reinvesting interest payments at much higher rates than 4.25%.


Potential Price Movement of a 5% Bond Over 20 Years (Rising Rate Environment)



Taking Income Scenario:

This scenario is simpler to conceptualize.  When you purchase bonds and then start using the income, you don’t get the benefit of reinvesting the interest payments.  While rising rates affect the value of your bonds on the statements you receive, it doesn’t affect the amount of income you receive.  I like clients to think of themselves in this scenario as a farmer.  Farmers don’t care as much about the value of the land as they do their crop yield.  Even though the value of the holdings may decrease between the time when you purchase a bond and when it matures, the income remains the same.  The reason why I’d like rates to rise over the course of ownership is that when the bonds mature and you need to buy more, I’d rather purchase higher income bonds than than lower income producing bonds.



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Author: Jared Toren

Jared Toren is CEO and Founder at Proper Wealth Management. Proper was born out of frustration with the inherent conflicts of interest at big brokerage firms influencing advisors to sell products that were not suitable for clients but profitable to the firm along with a consistently mixed message of who’s interest was supposed to be put first; the clients’, the firms’, shareholders or advisors.

At Proper, our clients interests come first. We are compensated the same regardless of which investments we utilize so there’s no incentive for us to sell high commission products. Since we focus on a small number of clients, we are able to truly tailor our advice to each person’s unique circumstances.