Invest in Municipal Bonds During Rate Hikes

Bonds and interest rates have an inverse correlation: as interest rates increase, bond prices fall. However, the more the Federal Reserve hikes interest rates, the better it is potentially for municipal bond investors.

Municipal bonds (or "munis"), long touted as among the safest, most tax-efficient debt investments available, were hit hard in the wake of the 2008 financial crisis as interest rates fell close to zero, and they were considered a low-yielding investment for many years. Let's see why munis can be more attractive to investors now that interest rates are rising.

Key Takeaways

  • Bond prices and interest rates are inversely correlated, and municipal bonds (i.e. debt securities issued by state and local governments) are no different.
  • Munis, however, have some unique advantages for investors to after an interest rate hike.
  • Investors should keep in mind the points explained below to see if a muni bond investment is right when interest rates increase.

How Interest Rates Affect Bond Prices

One of the most important concepts when investing in bonds of any type is the effect of interest rate changes on bond prices. Bonds are issued with interest rates, called coupon rates, that based on the current federal funds rate. That means 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 compensates 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.

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.

1. Higher Coupon Rates

The most obvious benefit of investing in municipal bonds after the rate hike is that coupon rates on newly issued bonds are substantially higher than on 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 municipal bonds, especially general obligation bonds, can be extremely safe if issued by a highly-rated municipality.

2. Greater Variety of Bonds

Another benefit of purchasing municipal bonds after the Fed hikes interest rates is that the number of bonds on the market is likely to increase. 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. But once interest rates rise and the cost of borrowing increases, bonds become the more attractive financing option. 

When a municipality issues bonds, its only responsibility is to repay investors according to the terms of the bond. There can be numerous strings attached to money borrowed from banks.

3. Potential for Appreciation If Rates Decline

In addition to their healthy coupon rates, bonds issued after a 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 of selling their bonds on the open market for a tidy profit rather than waiting for them to mature.

4. 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. Given that until 2022, 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.

This could provide an opportunity for investors to purchase highly-rated municipal bonds cheaply.

5. 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.

It should be noted that some muni bond returns are taxed at the federal level if the taxpayer is subject to the alternative minimum tax. This can occur if the bond is backed by a private corporation rather than a government body.

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 37% in the tax year 2022, so earning investment income that is not subject to federal taxes can mean a significant boost in after-tax returns.

What Are Municipal Bonds?

Municipal bonds are debt securities issued by state or local governments in order to raise cash for specific public projects or just to fund ongoing operations. The investor is loaning money to that government, and in return is getting interest payments until the bond reaches its maturity.

Any highly rated bond, municipal or corporate, is a relatively safe investment with a steady if unspectacular return. They are often chosen by retirees who want to add to their regular income or by investors of any age who want to protect some of their long-term savings from market volatility.

In times when interest rates rise, newly-issued bonds pay better.

Are Municipal Bonds Tax-Free?

Municipal bonds are almost always tax-free at the federal level. (The rare exception occurs when the bondholder is subject to the alternative minimum tax and the bond is backed by a private company rather than a government.)

Some bonds are tax-free at the state and local levels.

Since many municipal bond investors are retirees, it's worth noting that the interest earnings are counted in your adjusted gross income, and therefore may increase the amount of your Social Security that is taxed.

Are Municipal Bonds Rated?

Municipal bonds are rated by the same system that is used for corporate bonds. The rating reflects the credit rating agency's estimation of the creditworthiness of the bond's issuer. It's important to check that rating to make sure that the government or agency borrowing your money isn't skating on thin ice financially.

Article Sources
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  1. The Brookings Institution. "Key Changes in the Municipal Bond Market Since 2007."

  2. Board of Governors of the Federal Reserve System. "Implementation Note Issued July 27, 2022."

  3. Federal Reserve Bank of Philadelphia. "The Policy Perils of Low Interest Rates," Page 2.

  4. Internal Revenue Service. "Topic No. 409 Capital Gains and Losses."

  5. Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2022."

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