relationship between muni bond quality and impact of rising rates

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
Topic Author
15202guy
Posts: 177
Joined: Mon Jul 18, 2011 8:30 pm

relationship between muni bond quality and impact of rising rates

Post by 15202guy »

Could someone please explain the "theoretical" relationship between the quality of muni bonds and their performance in times of rising rates? In other words, should one expect a higher quality fund (e.g., BMBIX Baird Intermediate Muni Inst, which has a very high percentage of AAA/AA and pre-refunded bonds) to be more or less impacted by rising bond rates than a more typical fund (e.g., VWIUX Vang Intermediate Tax Exempt Adm)? I know the general rule regarding duration, but haven't found much info on how quality affects things.
Dandy
Posts: 6701
Joined: Sun Apr 25, 2010 7:42 pm

Re: relationship between muni bond quality and impact of rising rates

Post by Dandy »

Not me. But I will tell you theory and actual are often very different. In the 2008 crisis munis went down because hedge funds were getting creamed and one of the safest things they had that they could sell was muni bonds - so much for the relative safety of muni bonds.

Currently, I hear hedge funds are getting clobbered with their energy investments. So - I guess the message whatever the theory it is often an educated guess depending on a variety of other factors.
Topic Author
15202guy
Posts: 177
Joined: Mon Jul 18, 2011 8:30 pm

Re: relationship between muni bond quality and impact of rising rates

Post by 15202guy »

No one?

I recently read somewhere (wish I could remember where) that treasuries are more impacted by rising rates than riskier corporate bonds. So i wonder if the same logic applies to munis...that higher quality munis are more sensitive to rising interest rates than lower quality munis.
kolea
Posts: 1322
Joined: Fri Jul 11, 2014 5:30 pm
Location: Maui and Columbia River Gorge

Re: relationship between muni bond quality and impact of rising rates

Post by kolea »

Once the bond is issued a change in rate has no effect on the bond itself. Rising rates will affect those who hold those bonds, but only if they want to sell them before maturity. If they are held to maturity, a rising rate should have no effect on a bond holder. A falling rate would likely trigger a call by the borrower since most Muni bonds are callable. A change in rate, up or down, will affect the market price of the bond, but that is not a quality issue, it is purely a matter of what it is worth as an investment, and only affects the bond holder if he/she wants to sell it before maturity.
Kolea (pron. ko-lay-uh). Golden plover.
randomguy
Posts: 11295
Joined: Wed Sep 17, 2014 9:00 am

Re: relationship between muni bond quality and impact of rising rates

Post by randomguy »

15202guy wrote:No one?

I recently read somewhere (wish I could remember where) that treasuries are more impacted by rising rates than riskier corporate bonds. So i wonder if the same logic applies to munis...that higher quality munis are more sensitive to rising interest rates than lower quality munis.
Low paying debt is affected more. Credit rating doesn't matter. Imagine you have a 10 year bond fund where 1 pays 10% and the other pays 5%. Rates go up and the fund drops 10%. Fund a recovers in 1 year. Funb b is taking 2. Now that has been insanely simplified but I hope you get the general idea
Topic Author
15202guy
Posts: 177
Joined: Mon Jul 18, 2011 8:30 pm

Re: relationship between muni bond quality and impact of rising rates

Post by 15202guy »

RG -- yup, that makes sense. In practice, higher quality generally means lower rate, so in general, I think it's safe to say that higher quality debt is more affected.
User avatar
grabiner
Advisory Board
Posts: 35307
Joined: Tue Feb 20, 2007 10:58 pm
Location: Columbia, MD

Re: relationship between muni bond quality and impact of rising rates

Post by grabiner »

15202guy wrote:I recently read somewhere (wish I could remember where) that treasuries are more impacted by rising rates than riskier corporate bonds. So i wonder if the same logic applies to munis...that higher quality munis are more sensitive to rising interest rates than lower quality munis.
It's a matter of duration. Duration is the time-weighted average value of all future payments. A bond with a higher yield has more of its value in coupons, and less in its payments at maturity. Thus, if rates rise by 1% on both 10-year Treasury and corporate bonds, the Treasury bond will lose more value because more of its value is in the payment 10 years from now.
Wiki David Grabiner
Topic Author
15202guy
Posts: 177
Joined: Mon Jul 18, 2011 8:30 pm

Re: relationship between muni bond quality and impact of rising rates

Post by 15202guy »

grabiner -- are you saying that there is NO difference in how 2 bonds of unequal quality will react to an interest rate move if they have the same duration?
User avatar
grabiner
Advisory Board
Posts: 35307
Joined: Tue Feb 20, 2007 10:58 pm
Location: Columbia, MD

Re: relationship between muni bond quality and impact of rising rates

Post by grabiner »

15202guy wrote:grabiner -- are you saying that there is NO difference in how 2 bonds of unequal quality will react to an interest rate move if they have the same duration?
Duration is a measure of how bonds react to changes in their own yields (or, more precisely, the other way around). If a bond has a 5-year duration, and its price falls by 5%, its yield rises by 1%. Two different bonds which have the same duration will have the same reaction if both have their yields rise by 1%. (This is not quite true because of convexity issues, which cause duration to change as rates change. A callable bond will lose more if rates rise than a non-callable bond of the same current duration, as the rising rates will make it less likely that the callable bond will be called.)

The other issue is that rates do not rise by the same amount on all bonds. If junk-bond yields rise more than investment-grade bond yields (which tends to happen in economic downturns), junk bonds may lose more even though they have shorter durations.
Wiki David Grabiner
Topic Author
15202guy
Posts: 177
Joined: Mon Jul 18, 2011 8:30 pm

Re: relationship between muni bond quality and impact of rising rates

Post by 15202guy »

Thanks. It sounds like there isn't a simple rule of thumb that I can rely on, so in the classic Boglehead manner, I'll address the uncertainty by diversifying :)
alex_686
Posts: 13320
Joined: Mon Feb 09, 2015 1:39 pm

Re: relationship between muni bond quality and impact of rising rates

Post by alex_686 »

15202guy wrote:Thanks. It sounds like there isn't a simple rule of thumb that I can rely on, so in the classic Boglehead manner, I'll address the uncertainty by diversifying :)
There is a simple rule of thumb - there is no theoretical impact relationship between the quality of muni bonds and their performance in times of rising rates beyond duration.

Here is the theory:
Price of bond = (Real Interest Rate + Expected Inflation Risk + Credit Spread +/- Option Adjusted Spread(OAS)) / ( 1 - Tax Advantage)

Fluctuations of interest rates rates, up or down, get bundled into Real Intranet Rate and Expected Inflation Risk which is measured in duration.

Raising rates could decease the value of the OAS, but the negative impact of duration would be much greater.

Which takes us to credit spread, or the quality of the bond. It is independent of interest rate.

Kind of. You have to ask why interest rates are rising. If it is because of inflation this is not a good sign. City and state governments can have a hard time. On the other hand, higher real rates could be a positive sign. It means the economy is strengthening and that cities must pay higher rates to match higher and more productive private investment.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
Post Reply