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The Time-Varying Interest Rate Sensitivity of Municipal Bonds

This article demonstrates that municipal bonds’ interest rate sensitivity is a function of how inexpensive municipal bonds are relative to Treasury bonds. The difference between municipal bond yields and Treasury bond yields is used to measure their relative cost. Key results are that 1) the less expensive municipal bonds are relative to Treasury bonds, the lower the interest rate sensitivity of municipal bonds; and 2) after controlling for the level of municipal bond yields, the cheaper municipal bonds are relative to Treasury bonds, the higher the return on municipal bonds. These results have important implications for investors seeking to hedge the interest rate risk of municipal bonds or to evaluate municipal bond investment opportunities.