You might invest in municipal bonds for a variety of reasons. Bond prices tend to be less volatile than stock prices, so there is a perceived sense of safety, and municipal bond interest payments produce a predictable stream of tax-free income. But rising inflation can eat away at your buying power, so even if your municipal bond investments can be classified as conservative, they are not immune to economic forces.
Municipal Bond Ratings
Municipal bonds are commonly rated for their creditworthiness by an independent organization, such as Standard and Poor's, Fitch Ratings or Moody's. Bonds that receive a top rating from these organizations are commonly referred to as investment grade bonds. These ratings are based on the rating company's evaluation of the issuer's ability and willingness to repay both the interest and principal on the bonds as they come due. A higher rating typically indicates a lower risk, but a bond's rating is not a guarantee. If inflation increases, it can affect a municipality's ability to meet its obligations, which could result in a downgrading of its credit rating. A downgraded rating could result in a drop in your bond's market price.
After their initial offering, municipal bonds typically trade in the secondary market. Like most marketable debt securities, market prices for municipal bonds are sensitive to interest rates. If prevailing interest rates rise, the market price of existing municipal bonds will decline to stay competitive. If you hold your municipal bonds until they mature, you'll still get the bond's full face value, but if you have to sell early, you could take a loss.
Inflation and Interest Rates
Inflation is one of many market forces that can drive prevailing interest rates higher. As the cost of living increases, lenders want to maintain their buying power, so they increase the amount of interest they charge on their loans to keep pace. Rising interest rates drive down the market price of existing municipal bonds. You have the option of selling your bonds for less than their face value, then reinvesting in new bonds with a higher interest rate, or keeping your bonds and settling for the lower interest payout.
One of the benefits of investing in equity securities, such as stocks, is their ability to compensate for inflation. Debt securities, such as municipal bonds, typically have greater price stability, particularly as the bond approaches maturity, but their face values don't increase along with inflation. If you bought municipal bonds with a face value of $10,000, you'll receive $10,000 when those bonds mature. But if inflation rises, that $10,000 might only buy $9,000 worth of goods and services. Even if the face value of your investment is safe, inflation can erode the true value of your money.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.