Final answer:
MSRB rules dictate that dealers must quote municipal bonds at a price reflective of the fair market value. If interest rates rise, the bond's price will often decrease to attract investors, since newly issued bonds will carry the higher current rate. Thus, a bond bought at a time when interest rates have increased will likely cost less than its face value.
Step-by-step explanation:
When considering the municipal bond market, it's important to understand how bond prices are affected by changes in interest rates. MSRB rules require dealers to quote bonds in a manner consistent with fair market value. If interest rates rise, the value or price of existing bonds generally falls. This is because new bonds are likely to be issued at the higher current interest rate, making existing bonds with lower rates less attractive.
For instance, imagine a local water company issued a $10,000 ten-year bond at an interest rate of 6%. If you were considering buying this bond one year before its maturity, but the current interest rates have risen to 9%, you would expect to pay less than the face value of $10,000 for the bond. The bond would be priced lower to compensate for the lower interest rate it pays compared to the current market rate of 9%.
Similarly, in a scenario where a no-risk bond was originally issued at $1,000 paying an 8% interest rate, and over time the market interest rates increase to 12%, the bond's price would be reduced below its face value. This is to make the bond sufficiently attractive to a buyer who could otherwise invest in a new bond that pays the higher 12% rate. The bond seller needs to lower the price to reflect the fact that the bond is an unattractive investment at its original face value given the current higher interest rates.