With the U.S. economy in recovery, investors and analysts have been predicting an interest rate hike for a few years. Still, in 2015, no such increase has occurred. However, the longer the Federal Reserve delays the inevitable, the more likely it is the hike is just around the corner.
Many in the media and investment community spend a lot of time waxing catastrophic about what happens to the value of current bonds when rates rise. Even municipal bonds, long touted as one of the safest, most tax-efficient debt investments available, are suffering the wrath of the media's alarmist pessimism. However, no one seems to be discussing the benefits of investing in bonds after interest rates rise. Rather than focusing on the deleterious effects of an interest rate jump on current investments, learn the top five reasons investing in municipal bonds after the hike can be a lucrative move.
Municipal Bonds: The Basics
Municipal bonds are debt instruments issued by state or local governments to fund various projects or finance government needs. Typically, these bonds are issued to fund the construction of schools, roads, and bridges or other infrastructure projects.
There are a few different types of municipal (muni) bonds, such as general obligation, revenue and conduit, that carry varying levels of risk. Of course, if the issuing municipality declares bankruptcy, which is uncommon but not unprecedented, bondholders may not recoup the full value of their investments.
How Interest Rates Affect Bond Prices
One of the most important concepts to understand when investing in bonds of any type is the effect of interest rate changes on bond prices. Because bonds are issued with interest rates, called coupon rates, based on the current federal funds rate, changes to interest rates initiated by the Federal Reserve can cause the values of existing bonds to increase or decrease.
For example, if a current bond is issued with a coupon rate of 4%, the value of the bond automatically decreases if interest rates rise and a new bond with identical terms is issued with a 6% coupon. This reduction in market value occurs to compensate investors for purchasing a bond with lower interest payments than newly issued bonds. Conversely, if interest rates decline and new bonds were issued with 2% rates, the market value of the original bond increases.
Long Vs. Short-Term Bonds
Typically, longer-term bonds carry higher coupon rates than short-term bonds because the default and interest rate risk inherent in all bond investments increases with time. This simply means the longer you hold a bond, the more risk there is of interest rate changes rendering your bond less valuable or the issuing entity defaulting on its obligations, leaving the bond unpaid. However, if you invest in highly rated municipal bonds and do not need to access your investment funds for several years, long-term bonds can be a very lucrative investment when purchased at the right time.
Higher Coupon Rates
Of course, the most obvious benefit of investing in muni bonds after the rate hike is coupon rates on newly issued bonds are substantially higher than current bonds. New bonds issued after rates rise generate more interest income each month relative to previously issued securities, making them lucrative investments for those looking to supplement their annual income.
As always, longer-term bonds still carry higher rates than short-term securities because of the increased inflation and credit risk. However, long-term muni bonds, especially general obligation bonds, can be extremely safe if issued by a highly rated municipality. Holding long-term munis with high coupon rates is much less risky than holding a long-term bond with rock-bottom rates.
Greater Variety of Bonds
Another benefit of purchasing muni bonds after the Fed hikes interest rates is the number of bonds on the market is likely to increase, giving investors a greater number of options.
When interest rates are low, the cost of borrowing money from banks, through loans and lines of credit, is often cheaper than the cost of issuing bonds. In fact, analysts have noted a drastic decrease in municipal bond issuances and an increase in direct borrowing in recent years.
However, once interest rates rise and the cost of borrowing increases, bonds become the more attractive financing option because they require less of the issuing entity. When a municipality issues bonds, its only responsibility is to repay investors according to the terms of bond. Conversely, there can be numerous strings attached to money borrowed from banks. Banks can impose stringent limitations on how the borrower can use funds, whether the borrower is allowed to acquire additional debt and what kinds of financial transactions can be executed during the loan term.
Potential for Appreciation if Rates Decline
In addition to their healthy coupon rates, bonds issued after the rate hike are likely to increase in value down the road. If the Fed increases rates rapidly, the next substantial interest rate change is likely to be a reduction, since interest rates change in cycles. If interest rates decline a few years into the future, the value of bonds issued when rates were at their peak is higher, giving investors the option to sell their bonds on the open market for a tidy profit rather than waiting for them to mature.
Lower Prices on Existing Bonds
Though municipal bonds issued after a rate hike carry higher interest rates than current bonds, this means older bonds become extremely affordable. In fact, given that interest rates have been at historic lows for several years, existing bonds are likely to be purchasable at bargain-basement prices to compensate investors for the opportunity cost of investing in lower-yield bonds. However, this could provide an opportunity for investors to purchase highly rated municipal bonds cheaply. While the interest payments are not impressive, holding these discounted bonds until maturity could generate a tidy profit.
Greater Tax Savings
The chief benefit of investing in municipal bonds at any time is they earn interest that is not subject to federal income taxes. In addition, if you purchase bonds issued in your state or city of residence, your earnings may also be exempt from state or local taxes. If you purchase municipal bonds after interest rates rise, the amount you save on income taxes is even greater. Even long-term gains earned on investments held longer than one year are subject to capital gains rates of up to 20%. Ordinary income tax rates go up to 39.6%, so earning investment income that is not subject to federal taxes can mean a significant boost in after-tax returns.