How Are Municipal Bonds Traded?
Municipal bonds are generally not traded on an exchange like stocks, but rather trade on bond desks managed by major financial firms. Prices are often determined electronically, based on a number of external economic factors and the particular characteristics of the individual bond.
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Bond Desk
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A bond desk is a proprietary department of a financial firm that is dedicated to buying and selling bonds. Bond traders man the desks and help create a market for bonds, much like specialists create markets for stocks on the floor of the stock exchange. Bond desks are particularly important in municipal bond trading, as some corporate bonds trade on exchanges but municipal bonds are generally only traded by bond desks. To trade a bond, a trader will determine a fair market value of a bond based on its own characteristics and the current market environment. Trades are executed electronically.
Bond Characteristics
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The specific characteristics of a municipal bond determine how that bond will be traded. The most important factors affecting bond prices are the issuing municipality, the interest rate the bond pays and the maturity date of the bond. Bonds issued by financially secure municipalities and paying a high rate of interest are more desirable to investors than riskier, lower-interest bonds, so those bonds trade higher. Bonds with shorter maturity dates are generally less volatile than longer-maturity bonds, as investors are more certain of receiving their principal back with a shorter-maturity bond.
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Interest Rates
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The movement of interest rates in the marketplace affects how bonds are traded, as rising interest rates tend to depress bond values, and vice versa.
Bond Ratings
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A bond rating is an indication by an outside party of the financial strength of an issuer. Bond ratings generally range from "excellent" to "in default," and the higher a bond rating, the higher the price tends to be, all other things being equal. The top four ratings grades are known as "investment grade," and most financial firms such as banks are restricted from purchasing bonds rated below investment grade. Individual investors should also consider whether or not a lower-rated bond would be appropriate for their portfolio, as opposed to the relative security of investment-grade bonds.
Supply and Demand
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Supply and demand plays little role in the pricing and trading of bonds, which is very different from the way stocks trade. In order for a stock to move up in price, all of the stock from selling shareholders must be bought at a certain price before the stock will move up. Bonds do not move up based on buying pressure, but rather on the financial return that the bond can offer, given the current market environment.
Taxes and Fees
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The fee to buy or sell a municipal bond is largely up to the individual bond trader or broker. Some bonds can be sold net, or with no sales charge at all, while other brokers or firms may charge up to three percent of the bond's value as a fee. Capital gains taxes may be due on any bond that is sold at a profit.
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References
- Photo Credit 100-dollars bonds image by Olena Kucherenko from Fotolia.com
