Final answer:
When considering a purchase of a municipal revenue bond, market interest rates play a significant role in determining the bond's price. As interest rates increase, the price of existing bonds with lower rates typically decreases. If one were to buy a $10,000 bond with a 6% rate one year before maturity in a 9% market, they would likely pay less than the bond's face value.
Step-by-step explanation:
When evaluating whether to purchase a municipal revenue bond, it's crucial to understand how bond valuation works, particularly in the context of changing interest rates. Let's consider a scenario where a local water company issued a $10,000 ten-year bond at an interest rate of 6%. Now, with one year remaining until the bond's maturity, imagine that the general market interest rates have risen to 9%.
Firstly, one needs to consider that the bond's coupon rate remains fixed at 6%. This means that the bond will continue to pay $600 annually until it matures. However, since current market rates are higher, new bonds are being issued that pay 9%, which is more attractive to investors. Therefore, our original bond is now less appealing, and as a result, its price in the market must decrease to offer a competitive yield to potential buyers.
In this scenario, you would expect to pay less than $10,000 for the bond if you were buying it one year before maturity at the higher market rate of 9%. To calculate what you might be willing to pay, consider the bond's yield to maturity (YTM). YTM is the total return anticipated on a bond if the bond is held until it matures, and it's influenced by the purchase price, the face value, the coupon, and the time remaining to maturity.
Assuming you want a yield of 9%, you would be willing to pay a price that, when combined with the $600 of interest you would receive, equates to a 9% return on your investment over the final year. The bond's face value will be $10,000 at maturity, plus you'll receive a $600 interest payment in the last year. Therefore, to get a 9% yield, the price you'd be willing to pay (P) would be the sum that satisfies the equation (10,600 - P)/P = 0.09.
After rearranging and solving for P, you find that you would pay approximately $9,724.77 for the bond. Please note, this is an approximate figure and actual market prices would be determined by additional factors such as perceived risk and time value of money.
Conclusively, when interest rates rise, bonds with lower fixed interest rates become less valuable, and thus their market price declines. Conversely, when interest rates fall, older bonds with higher rates become more valuable, and their prices increase. Consideration of these principles is vital when investing in bonds.