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Muni bonds in a time of interest-rate uncertainty

Key takeaways

  • The Federal Reserve has raised interest rates from historically low levels but may change that policy.
  • Premium bonds may be less sensitive to changes in rates and may provide protection for investors' portfolios.
  • Premium bonds sell for more than their face value.
  • Most municipal bonds are issued at a premium.

As the Federal Reserve considers whether to continue its policy of hiking interest rates to slow inflation, this may a good time to know more about premium municipal bonds.

Premium bonds are bonds whose purchase prices are higher than the amount that the issuer promises to repay when the bond matures. Premium bonds may be attractive to investors because they pay more interest (and pay it sooner) than non-premium bonds do.

These benefits of premium bonds have long been understood by sophisticated institutional investors but individual investors can also gain exposure to them in separately managed accounts.

Historically, when rates have risen, the prices of premium bonds have been less sensitive than those of non-premium bonds. When interest rates have fallen, premium bonds have tended to underperform other muni bonds of identical maturity and credit quality.

To understand how premium bonds can offer protection against future rate moves, let's imagine 3 bonds, each with a $10,000 face value. Assuming the issuers don't default, all 3 would pay the same yield if they are held to maturity. One of the bonds sells for its face value, one sells at a discount, and the third, a "premium" bond, sells for $2,000 above face value. The premium bond pays its owner $500 or 5% of its face value every year until it matures, while the face value bond pays $265 or 2.65% of face value and the discount bond pays $200 or 2% of face value.

Those larger interest payments appeal to smart investors because they may offer some degree of protection from the risks posed by changes in interest rates. Interest-rate risk is one of those things that keeps experienced bond investors up at night. Put simply, interest-rate risk is the possibility that rates might rise in the future while all their cash remains tied up in bonds that pay less and they are unable to take advantage of the new higher rates.

How a premium bond compares to other bonds with the same face value1

  Discount bond Face value bond Premium bond
Price $9,432 $10,000 $12,053
Coupon (%) 2.00% 2.65% 5.00%
Annual interest paid $200 $265 $500
Effective duration2 9.08 8.85 8.2
Tax-equivalent yield (%)3 4.21% 4.21% 4.21%
1. Illustrative calculation. The above assumes newly purchased bond having a maturity date in 10 years.

2. Effective duration estimates the approximate change in price for a bond if interest rates change 100 basis points.

3. Tax-adjusted equivalent calculation uses a generic tax rate of 37% and provides a comparison of yield to taxable securities.

Discount is a bond traded for less than face value, par is a bond that trades at face value, and premium is a bond that trades at a price higher than face value.

Like many things in investing, the risk that changing interest rates pose to bonds can be measured and managed and premium bonds are one of the tools that can be used to manage that risk. To measure the amount of risk that changing rates pose to various bonds, investors look at a metric known as duration. Duration measures the sensitivity of a bond's price to changes in interest rates and lets an investor compare how sensitive various bonds would be to changes in interest rates. For example, a bond whose duration is 4 years is roughly twice as sensitive to rate changes as a bond with a 2-year duration. Duration also gives an investor an estimate for how much the price of a bond might change if interest rates rose or fell.

For example, a bond with a duration of 4 years would fall approximately 4% if rates were to rise 1%. The faster flow of interest payments to the bondholder that premium bonds offer reduces their duration and the possibility that they will lose value if rates increase in the future. In essence, premium bonds offer a different composition of total return (interest income, appreciation) than discount bonds, as well as a lower effective duration, all else being equal.

Bear in mind

While premium bonds have the potential to deliver higher cash flow and reduce rate risk, investors should be aware of some of their unique characteristics.


The issuer of a callable bond has the right to redeem the bond before it matures and the higher the interest rate that the bond pays relative to prevailing rates, the more likely the issuer may be to call it. Because premium bonds pay higher-than-average interest, premium bondholders should be aware of the earliest date their bonds could be called. The bond's yield based on that first call date, rather than its stated maturity, is called its "yield to worst."

Credit risk

While the historical default rates on municipal bonds and investment-grade bonds are low, it's wise to understand a bond issuer's creditworthiness to help avoid a loss if the issuer is downgraded or defaults. In an economic slowdown, the creditworthiness of municipalities and corporations could deteriorate, potentially raising default risk and lowering bond prices.


Taxes on bond investments can be complicated so be sure you understand the potential tax consequences of any investment before you make it. You may want to consult a tax professional.


It's important to maintain a diverse mix of investments in any fixed income portfolio. A properly diversified portfolio includes securities from a variety of sectors, with different credit ratings and maturities, to help manage both credit risk and interest rate risk.

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This information is intended to be educational and is not tailored to the investment needs of any specific investor.

Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.

In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible. Any fixed income security sold or redeemed prior to maturity may be subject to loss.

Diversification and asset allocation do not ensure a profit or guarantee against loss.

Past performance is no guarantee of future results.

Interest rate risk - Like all fixed income securities, the market prices of municipal bonds are susceptible to fluctuations in interest rates. If interest rates rise, market prices of existing bonds will decline, despite the lack of change in both the coupon rate and maturity. Bonds with longer maturities are generally more susceptible to changes in interest rates than bonds with shorter maturities.

Call risk - Many municipal bonds carry provisions that allow the issuer to call or redeem the bond prior to the actual maturity date. An issuer will typically call bonds when prevailing interest rates drop, making reinvestment less desirable for the holder. Some municipal bonds, including housing bonds and certificates of participation (COPs), may be callable at any time regardless of the stated call features. In some cases, bond issuers will call bonds to modify an indenture through a new offering. Investors should also be aware of special or extraordinary redemption provisions. These are provisions that give a bond issuer the right to call the bonds due to a one-time occurrence, such as a natural disaster, interruption to a revenue source, unexpended bond proceed, or cancelled projects.

Liquidity risk - The vast majority of municipal bonds are not traded on a regular basis; therefore, the market for a specific municipal bond may not be particularly liquid. This can be attributed to the large number of municipal issuers and variety of securities. With limited exceptions for some large more actively traded issues, the chances of finding a specific municipal bond in the secondary market at any given time are relatively small. According to the Municipal Securities Rulemaking Board (MSRB), it is much more common to identify basic characteristics of a municipal bond in which an investor is interested in investing (e.g., state, creditworthiness, maturity range, interest rate, or yield, market sector, etc.) and then to make a choice from a set of municipal securities that meet those criteria. Selling prior to maturity can present a challenge for municipal bond investors due to the fragmented and thinly traded nature of the market.

Revenue sources risk - With revenue bonds, the interest and principal are dependent on the revenues paid by users of a facility or service, or other dedicated revenues including those from special taxes. In general, the consumer spending that provides the funding or income stream for revenue bond issuers may be more vulnerable to changes in consumer tastes or a general economic downturn than the income stream for general obligation bond issuers. "Essentiality" is a key investor consideration for a project financed with revenue bonds. For example, a facility that delivers fundamental or essential services, such as water and sewer, may be more likely to have dependable revenues through multiple economic cycles. When evaluating revenue bonds, it is important to consider:

- The overall economic health of the region or customer base and the impact it might have on the entity's ability to sustain its revenues.
- The exact source of the revenues that will service and repay the debt. Is the bond solely dependent upon one source of revenue or is a larger entity standing behind the issue?
- The entity's track record of operational effectiveness through multiple economic cycles. Is there a track-record of solid growth attracting more customers or taxpayers from more diverse sources?
- The legal provisions that may be in place to protect the bondholder, such as rate covenants and debt service reserve funds.
- The competence of financial management of the entity. Has its credit rating been maintained or strengthened over a period of time?
- How has it weathered previous economic downturns? How much debt does it have? How much of its cash flow is committed to paying down debt vs. investing in new projects or supporting services of value for the community?

Credit and default risk - Credit risk is the risk that the issuer will default or be unable to make required principal or interest payments. Despite the fact that many municipal bonds have high credit ratings, there is a risk of default in any bond investment.

Tax risks - Because tax-exempt interest generated by municipal bonds is usually more beneficial for investors in higher tax brackets, municipal bonds may not be appropriate for all investors, particularly those in lower tax brackets. In addition, if you are subject to the federal alternative minimum tax (AMT), the interest income generated by certain municipal bonds (mainly private activity bonds) may be taxable.

Inflation risks - As with all bonds, investors run the risk that inflation will diminish the purchasing power of a municipal bond's principal and interest income.

Repudiation risk - There can be no assurance that bonds validly issued will not be partially or totally repudiated by the issuing state or municipality, should that be deemed reasonable and necessary to serve other important public purposes.

Other risks - Not all risks can be quantified in a bond's prospectus or offering circular. A type of risk called "special event risk," lawsuits or significant legal changes, another community's public works project, unusual weather, an economic downturn, or other events could impact the issuer's ability to meet their financial commitments.

Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation.

Tax-advantaged accounts such as IRAs and 401(k)s are generally not appropriate for holding tax-exempt municipal securities. The content in this piece is provided for informational purposes only, and any references to securities listed herein do not constitute recommendations to buy or sell. The content herein is valid only as of the date published and is subject to change because of market conditions or for other reasons. The information and opinions presented are current as of the date of writing without regard to the date on which you may access this information.

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