Evaluating a Municipal Bond

When choosing investments, many bond investors focus only on yield and the creditworthiness of the borrower. However, there are many other factors to consider when deciding whether and how to invest in municipal bonds.

Hold to maturity or trade?

If you hold a bond until it matures and the issuer doesn't default on it, you know what you'll receive: the interest owed on the bond from the date of purchase plus the principal. However, if you sell it before maturity, your return is less certain. You may not get the price you paid for it, or you could profit if bond prices rise and you're able to sell your bond for more than you paid for it.

If you want to hold a bond to maturity, check to see if it has call protection that would prevent early repayment of the bond, which would end your income from it. Also, be realistic about whether you'll be able to hold a 20- or 30-year bond to maturity. The longer the term, the greater the risk that you might have to sell it prematurely, even if it is worth less than you paid for it.

New issue or existing bond?

With a new issue priced at par (face value), you'll be assured of getting back your entire investment, assuming you hold it to maturity and the issuer doesn't default. Also, the costs of buying a new issue may be lower. On the other hand, depending on when a bond is issued, interest rates and yields on some older bonds might be higher than current rates. In that case, such a bond would trade at a premium to par; at maturity an investor would receive only the bond's par value, not any premium paid at purchase.

Interest-rate risk

If you hold your bond until it matures, the direction of interest rates won't affect you. However, if you sell it before maturity, changes in interest rates will affect your return. The interest rate a bond pays (its coupon rate) may be fixed, but its price isn't. Neither is its yield, which takes into account both the coupon rate and the bond's price.

Bond prices move in the opposite direction from interest rates. When rates are rising, bond prices tend to drop, and you could receive less than your original investment. That's because investors aren't as interested in buying a bond with, say, a 5% interest rate if they can buy a newer bond issue that offers 6%. If interest rates fall and new bonds are being issued with a 4% interest rate, an older bond that pays 5% becomes more valuable.

To estimate how much impact interest rate changes will have on a specific bond, you should consider:

• Its coupon rate: generally, the lower its coupon rate, the more volatile a bond will be
• The time to maturity: generally, prices on long-term bonds will fluctuate more than those for short-term bonds
• Whether it is callable: a callable bond's price may not appreciate as much as that of an equivalent noncallable bond when interest rates fall

Call risk

If you're relying on income from a bond, you'll probably want to know how long you'll receive that income. You should find out if it's callable (i.e., if it includes a provision that lets the issuer retire the bond early by repaying the loan in full). Call risk means that with a callable bond, you can't be sure how long your income stream will last. Because of call risk, callable bonds may offer a higher yield or a call premium that will be paid only if the bond is called. When estimating a callable bond's yield, you should know not only its yield to maturity but its yield to call (the yield based on the earliest date the bond could be called). A period of falling interest rates often increases the odds of a bond being called, because the issuer may be able to refinance the debt at a lower rate.

Inflation risk

If the payment amount on a municipal bond is fixed but inflation pushes prices higher, not only does the purchasing power of those interest payments fall, but the bond's value also drops as a result. The greater the rate of inflation, the less valuable fixed payments become.