Did My Muni Bond Really Lose 20% of Its Value? - TheStreet

In June, I bought a large quantity of insured, 30-year Illinois waterworks bonds to return 5.1% through my Edward Jones broker. Within three months, the quoted value was 80% of my original investment. Is the drop an unusually large one, and is the quote just an arbitrary number? -- Steve Johnson

Steve,

The drop was unusually large, but municipal bonds have been in an unusually large bear market.

And your bond is of the variety that gets hurt most in a bear market.

As for whether the quote is just an arbitrary number: It's complicated, but no, not really.

I'm going to guess that your bond is

Southwestern Illinois Development Authority

for

Illinois-American Water

. The utility issued $31 million of 30-year, 5.1% coupon bonds at par in June. The bonds were insured by

MBIA

(MBI) - Get Report

and

Edward Jones

was the underwriter.

Now, as you probably know, most muni bonds don't trade every day. (The

Bond Market Association's

Web site each day lets you see a list of bonds that traded the previous day. Both Thursday and Friday, your bond wasn't on it.)

Still, most bonds have to be priced, or assigned a value, each day, for the simple reason that portfolios -- and mutual funds in particular -- have to be valued on a daily basis.

To do this, mutual fund companies rely on bond-pricing services. The pricing-service folks talk to trading desks to find out the price levels at which trades have been getting done. Then, based on that information, they can impute a value for every bond they need to price. For example, if they know the price at which a 30-year insured general obligation bond from Illinois traded, they can assign a value to your bond based on the current relative value of insured Illinois general obligation and revenue bonds. It's more complicated than that, of course. The pricing services have it down to a science. So while not every price reflects an actual trade, you'd probably be hard-pressed to sell a bond for more than a pricing service says it's worth.

Some brokerages also rely on pricing services to tell their clients what their bond portfolios are worth. That's what Edward Jones does, a spokeswoman said.

J.R. Rieger, vice president at

Standard & Poor's J.J. Kenny

, a leading bond pricing service, described your bond's progress to me as follows: By the end of September, its yield had risen a full point to 6.10%, dropping its price to 86.355 (or $863.55 for each $1,000 of face value). By the end of October, it yielded 6.286% at a price of 84.149. It improved slightly in November, but by the end of the year was worth 82.073 to yield 6.47%. And it lost still more value last month, falling to 80.320 as its yield rose to 6.630%.

Let's have a look at the performance of the entire muni bond market over that initial three-month period. The

Merrill Lynch Municipal Master Index

, a proxy, returned negative 2.62% over the period. That in itself is an unusually large drop. As this table shows, it's the 10th-worst of all the three-month periods in the last decade.

As previous Fixed-Income Forums have discussed in greater detail (see

Nov. 12 and

Jan. 7), muni bonds had a terrible year last year, in part for the simple reason that interest rates rose a lot. At the same time, much of the demand for munis from institutional investors dried up as corporate bonds became cheaper on a relative basis.

Your bond performed much worse than the index for two basic reasons.

First, because it's a long-maturity issue, and long-maturity issues have the greatest price sensitivity. That means their prices rise most when interest rates fall and fall most when interest rates rise.

Also, your bond is insured. That's great from a credit perspective -- MBIA will make the payments if Illinois-American Water runs into any problems. But insurance makes your bond more price-sensitive.

You may remember from the

column on duration that if two bonds of identical maturity have different-sized coupons, the one with the smaller coupon will be more price-sensitive. That's because larger coupons take more of the sting out of any rise in interest rates. Because insurance improves your bond's quality, it carries a smaller coupon than it would without insurance. It's comparable to why Treasury bonds carry smaller coupons than corporate bonds, where the risk of default is greater, and why the Treasuries have more price sensitivity.

Send your questions and comments to

fixed-incomeforum@thestreet.com, and please include your full name.

TSC Fixed-Income Forum aims to provide general bond information. Under no circumstances does the information in this column represent a recommendation to buy or sell bonds, funds or other securities.