Municipal bonds are essentially I.O.U.s issued by state and local governments. Investors loan money to a municipality in exchange for interest payments and the return of capital at maturity. Since most municipal bonds are free from federal tax -- and many are free from state and local taxes as well -- they're attractive investments to high-income taxpayers. The price of a municipal bond depends on numerous factors, including when you buy it and current market conditions.
Par value, also known as the face value of a bond, is what investors receive in principal when the bond matures. For most bonds, par value is $1,000. The price of a bond at any time may be above or below par value. Bonds priced above par value are said to trade at a premium, while bonds below par value trade at a discount. For example, if you buy at bond for $970, the bond is trading at a $30 discount. In addition to earning interest while you own the bond, you'll receive $1,000 at maturity.
Bond Prices and Interest Rates
Regardless of what you paid when you bought a bond, the price of your bond will change frequently based on current market interest rates. As interest rates rise, bond prices fall. If you buy a bond that pays five percent interest and rates rise to seven percent, your bond will no longer be in demand. The amount of the price drop will depend on the duration of the bond.
Duration is a measure of a bond's risk that incorporates various features of the bond, including the interest rate and maturity date, into a measure of price sensitivity. For every year of a bond's duration, the price will drop one percent with a one percent rise in market interest rates. Using the above example, if your five percent bond had a duration of 10 years, it would drop in price by 20 percent if rates rose to seven percent.
One of the benefits of buying municipal bonds is that if you hold them to maturity, the short-term price fluctuations won't matter. No matter how high interest rates rise, you'll be paid back the full par value at maturity.
If you buy your municipal bond when it is first issued to the public, you may not have to pay any fees at all. However, if you buy bonds in the secondary market, after their initial offering, you'll typically have to pay your broker a commission. For municipal bonds, the average fee is about $17 per every $1,000 bond. This cost is added on to the current market price of the bond.
John Csiszar earned a Certified Financial Planner designation and served for 18 years as an investment counselor before becoming a writing and editing contractor for various private clients. In addition to writing thousands of articles for various online publications, he has published five educational books for young adults.