The threat of rising interest rates is not welcome news for municipal bond investors. As the economy comes out of recession, the threat of inflation may result in interest rate increases. This will consequentially lead to a lowering of bond prices as bond yields rise. To determine the possible effect of changes in interest rates on municipal bond prices, the BondView Stress Test calculator was created to easily allow a user to vary interest rates, in 50 basis point increments from +/- 550 basis points, and show the resulting price change in a municipal bond, or a whole bond portfolio, given the current price, coupon rate and maturity.
The interest rate was increased by 550 basis points to change the estimated price of this bond.
A Stress Test, also known in the bond industry as a “Shock Test“, uses two financial concepts to calculate changes in bond prices as interest rates change: 1) Modified Duration and 2) Convexity. Using duration, it’s possible to approximate how much a bond’s price is likely to rise or fall when interest rates change. As interest rates increase, a bond’s price decreases. Duration measures how quickly a bond will repay its price. The longer it takes, the greater exposure the bond has to changes in the interest rate environment. Therefore, the longer the duration, the higher is the interest rate risk (as opposed to default risk).
The effect of a 500 basis point movement on the bonds price
Modified duration, uses the duration to calculate the price change of a bond based on the change in yield, maturity and current price. Convexity is a measure of the curvature (non-linear) relationship of a bond’s price change to yield changes. As yields increase, bond prices fall at a decreasing rate. That is, the price fall is not directly proportional to the change in yield as the case using modified duration. The BondView stress test adds a convexity correction to the modified duration to account for this.
Tags: bondview, convexity, duration, interest rates, municipal bonds, stress test
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Helen,I am in the municipal lseiang business and have been a licensed securities broker (no longer active) so I have a pretty good understanding of this stuff. Some of the other commenters (David, Stephen S, Dave F, Jason) have left you some very good information/advice. I’d like to add a couple of things.When you buy a bond, muni or otherwise, you should be buying it for current income and consider it a buy and hold investment. As David pointed out, the value of the bond can vary quite a bit in the near term as new issues come out with higher or lower interest rates. My mother took a pretty hefty loss on some corporate bonds because she didn’t understand this and when the value of the bond went down due to a rise in general rates she sold it. Had she held onto it until maturity, she would have gotten her money back. In other words, she treated it more like a stock investment than a bond investment.Unless you are in a very high tax bracket, munis may not make sense when compared to more widely issued/heavily traded taxable corporate issues. If you are in say, an 18% bracket, for the 4% bond that was cited above, your taxable equivalent yield would only be about 4.87% (coupon rate divided by 1-tax bracket %, e.eg. 4/1-0.18). At the 35% bracket your taxable equivalent yield would be 6.15%, so look at what you can get from a high quality corporate bond before you buy muni. Also, keep in mind that only the interest earned is tax free. You still have to pay capital gains tax on any profitable sales if you sell before maturity. You may even have to pay taxes on value appreciation if you buy at a discount from par and hold the bond to maturity. If you are looking to shelter capital and let it grow, the suggestion by Serket to put something in a Roth IRA is a good one. This allows you to put away after tax dollars which you will be able to invest in stocks, mutual funds, etc., and not pay any taxes on interest, dividends, captial gains, etc. When it comes time to start taking money out, it will be tax free because you invested after-tax dollars.I’d strongly suggest you get a good financial planner (fee-based, not commissioned) to help you sort out what your goals are and how to achieve them because as I think you probably see now, muni investing is not as simple as just collecting tax free interest.Just my $0.02. Hope it helps.