Are All New Issue Municipal Bonds Issued at Par?

Municipal bonds are debt securities issued by state and local governments to fund various public projects, such as infrastructure development or school construction. In exchange, the issuer promises to make regular interest payments and return the bond’s face value, known as par value, at maturity. While some municipal bonds are issued at par, not all are; they can also be issued at a discount or a premium depending on prevailing market conditions.

Understanding Par Value in Bonds

Par value, also called face value or principal amount, represents the amount of money an investor will receive back when a bond matures, assuming no default. This value is fixed at the bond’s issuance and does not change with market fluctuations. For municipal bonds, the par value is commonly set at $1,000, though it can vary, sometimes appearing in larger denominations like $5,000 or $10,000.

The par value serves as the base for calculating the bond’s coupon interest payments. For instance, a bond with a $1,000 par value and a 5% coupon rate will pay $50 in annual interest. Interest payments are made semi-annually until maturity. Par value is a reference point for the issuer’s repayment and the investor’s income.

Bonds Issued Below Par Value

A bond issued “below par” means it is sold at a discount, costing less than its face value but still maturing at par. For example, a $1,000 par value bond might be issued for $980. This occurs when the bond’s stated coupon rate is lower than the prevailing market interest rates for comparable bonds, making the initial yield less attractive to investors. Issuers may also price bonds at a discount if there are perceived credit risks associated with the municipality.

For municipal bonds, a discount at original issuance is known as Original Issue Discount (OID). The difference between the discounted issue price and the par value at maturity is considered tax-exempt interest income for federal purposes, provided the bond is held until maturity. However, if a bond is acquired in the secondary market at a discount, tax rules can differ, and the gain may be subject to ordinary income or capital gains taxes under certain conditions.

Bonds Issued Above Par Value

When a bond is issued “above par,” it means it is sold at a premium, costing more than its face value, but it will still be redeemed at par at maturity. For instance, a $1,000 par value bond might be issued for $1,020. This pricing happens when the bond’s stated coupon rate is higher than the current market interest rates for similar bonds, making the higher interest payments appealing to investors.

For municipal bonds purchased at a premium, the investor must account for bond premium amortization for tax purposes. This process involves systematically reducing the bond’s cost basis over its life to reflect the premium paid. Although municipal bond interest is tax-exempt, the amortized portion of the premium reduces the amount of tax-exempt interest received annually. This adjustment ensures that by maturity, the investor’s adjusted cost basis equals the par value, preventing a capital loss at redemption.

Key Determinants of Issuance Price

Several factors influence whether a new issue municipal bond is priced at par, a discount, or a premium. Prevailing market interest rates are a primary determinant; if market rates for similar bonds are higher than the bond’s proposed coupon rate, it will likely be issued at a discount to attract investors. Conversely, if the bond’s coupon rate is higher than current market rates, it can be issued at a premium.

The issuer’s creditworthiness also plays a role. Municipalities with strong credit ratings may offer lower interest rates and still attract investors, potentially leading to premium pricing if their coupon is competitive. However, if there are concerns about an issuer’s financial health, a discount might be necessary to compensate investors for the increased risk. Supply and demand dynamics, influenced by economic conditions and investor preferences, also impact pricing.

Investor Considerations for Different Issuance Prices

The initial issuance price of a municipal bond impacts an investor’s overall return. For bonds issued at a discount, the total return includes both the regular coupon interest and the capital appreciation realized as the bond’s value approaches par at maturity. This combination results in an effective yield, or yield to maturity (YTM), that is higher than the stated coupon rate.

Conversely, for bonds issued at a premium, the effective yield will be lower than the stated coupon rate. This is because the investor pays more than the par value upfront, and this premium is gradually amortized over the bond’s life, reducing the overall return to par at maturity. While the higher coupon payments of premium bonds provide more immediate cash flow, the amortization reduces the tax-exempt income for municipal bonds, influencing the net return.