Every municipal bond trade has 5 basic elements. The 5 elements are maturity date, interest rate, price, $ amount traded, and yield.
3 of the 5 elements are similar to the elements of a bank CD. For a CD, these are the amount invested, the length of the CD, and the interest rate. For a municipal bond, the 3 similar concepts are face value, maturity, and interest rate.
Maturity: Like the length of a CD, every municipal bond issue has a maturity date; this is when the issuer, the municipality, has to pay back the money it borrowed when it originally issued the bond. If an investor held the bond until the maturity year, this is the point at which the bonds will be redeemed or paid back. Most municipal bonds are issued with maturity dates longer than 10 years, usually more than 20 years.
Interest Rate: This is also known as the ‘coupon’. Municipal bonds pay interest. On most municipal bonds, the issuer (town, state, school district…) will pay the interest rate specified in the bond. This interest payment is generally paid semi-annually or once every 6-months. For example: A 4% coupon on $100,000 worth of bonds would receive $2,000 every 6-months paid by the issuer.
Amount Traded/Face Value of Bonds: Also known as par value, this is the amount that the investor will be paid back at the maturity date. If an investor purchases $10,000 worth of bonds, this means that the bonds at maturity will be redeemed for $10,000. On MunicipalBonds.com data pages where we report trades, we call this the ‘amount traded’.
Example: This is a series of trades for a bond issued by the Beverly Hills Unified School District.
In the example above, this Beverly Hills School bond issue has a maturity date of August 2026. It pays 5% interest on the amounts traded. Each trade above is a different investor buying or selling this Beverly Hills Unified School District bond issue.
The 2 more complicated components: Yield and Price
Investors should fully understand the concepts of yield and price before investing in bonds. Price and yield are the only elements of a bond that fluctuate based on market conditions.
Price: All bond trades and investments include a component called ‘price’. The best way to understand the concept of ‘price’ is to think of this as ‘cents on the dollar’. All bonds are basically quoted as cents on the dollar; 100 is par or 100 cents on the dollar. A price of 100 would mean that $10,000 worth of bonds would cost you $10,000. A price of 95 means that $10,000 worth of bonds would cost you $9,500. A price of 103 means that $10,000 worth of bonds would cost you $10,300.
In the Beverly Hills trade example below, $20,000 of face value were bought by an investor at a price of 107.246. This means the investor paid 107 cents on the dollar which is the equivalent of $21,449. (1.07 times $20,000=$21,449.) This is what the investor paid the seller.
On his investment of $21,449, he is going to collect 5% interest on the face value of $20,000; this is $1,000 per year. (Interest payments are generally made every 6 months, so he will receive $500 every 6 months.)
If he keeps the bond to maturity to August 2026, the Beverly Hills School District will pay him $20,000 to redeem the bonds. If he keeps his bonds to maturity, he would have earned a yield of 2.815%. Here’s why:
Since he paid $21,449 for bonds that will be redeemed at for $20,000, his annual return is not simply the $1,000 he receives in interest payments every year.
Something has to also account for the fact that he will be receiving $1,449 less at maturity than he paid; factoring in all of this is the concept of ‘yield’. His yield of 2.815% will be this investor’s actual percentage return if he holds to maturity.
Yield: The yield is the overall percentage return that investors will receive. Yield factors in maturity, interest rate, and price to give investors a number that is the actual return on each investment.
The reason that bonds sell for more or less than their face value is due to a variety of reasons. The most common reasons are changes in interest rates and perceived changes in credit risk. In our Beverly Hills case above, the investor feels that a yield of 2.815% is a good deal considering that Beverly Hills School District is a good credit risk. Beverly Hills collects money from property taxes; the assumption is that this will not be at risk over the next 17 years. He might also make a comparison to other investment products such as CDs and US treasuries that are yielding less on a tax-equivalent basis. (Remember, a taxpayer in California does not have to pay State or Federal income tax on the interest earned from municipal bonds.)
Based on other comparable interest-bearing investments, the investor has decided that the safety and tax-free elements make 2.815% yield through 2026 acceptable to him.
Another Example of Yield and Price:
Let’s suppose that an investor bought $10,000 worth of bonds with a 5% coupon with a 20-year maturity at a price of 100; this means he paid $10,000 for $10,000 worth of bonds. After 10 years, he decides he wants to sell the bonds; the investor still has 10 years left before his bonds mature.
Let’s say that current interest rates on similar bonds that mature in 10 years are now paying 7%, but our investor’s bonds are only paying 5% interest. Our investor will have to sell his bonds for less than a price of 100 or less than $10,000 to account for the fact that his bonds are only paying 5% interest. Our investor will have to price his bonds lower than the face value to make it attractive compared to newly-issued bonds that pay 7%.
Yield: Yield is the actual % return that an investor receives from a bond investment. Yield and interest rate are closely related, but can be widely different based on current market conditions. The interest rate on any bond is a fixed component. An issuer agrees to pay a set rate of interest for the life of the bond regardless of the market (think of it as a fixed-rate mortgage). Yield is based on market conditions and the market for bonds.
In our example above, our investor will be selling his $10,000 worth of bonds for less than $10,000. His bonds pay an interest of 5% or $500 per year. Let’s say that a buyer purchases the bonds for a price of 95 or $9,500. The buyer will now be receiving $500 per year in interest on his $9,500 investment. $500 interest on $9,500 is greater than 5%. In addition, at maturity, the bonds will be redeemed for the face value of $10,000 even though the investor paid $9,500. The yield adjusts for the discounted price that the buyer paid for the bonds.
The yield is the overall return that investors receive from bond investments. When bonds are priced at 100 or par value, the interest rate and the yield will be almost identical. If the bonds trade for more than 100, the yield will generally be lower than the interest rate. If the bonds trade for less than 100, the yield will be generally higher than the interest rate.
Please make sure that you understand the concept of yield and price thoroughly before investing in bonds on your own.
