Investing in bonds can be an attractive option if you are looking for a stable income stream and lower-risk investment compared to the stock market. However, picking the right bonds for your portfolio can be tricky.
Two common bond types are corporate bonds and municipal bonds, each with differing pros and cons. While municipal bonds offer preferential tax treatment, corporate bonds can provide higher yields. Let’s explore the differences between municipal and corporate bonds and their potential benefits to help you make an informed investment decision.
- Corporate bonds are debt securities issued by corporations to finance their operations, while municipal bonds are debt securities issued by state and local governments to finance public projects.
- We’ll compare their risk levels, tax implications, risk-to-reward ratio, liquidity, and more.
Corporate bonds are a type of debt security large companies issue to raise funds from investors to finance capital projects. This form of debt financing allows businesses to raise money for market research, expansion, and other projects without giving up ownership stake or control in the company.
By issuing bonds, companies can borrow money from investors in exchange for making regular interest payments over a set period. These interest payments typically get paid out semi-annually or annually. The principal investment is then repaid at the municipal bond’s maturity date, ranging from a few years to several decades.
Corporate bonds are rated by credit rating agencies, such as Standard & Poor’s and Moody’s, based on the creditworthiness of the issuing company. A higher credit rating typically indicates a lower risk of default, which can result in a lower interest rate for the investor.
One advantage of corporate bonds is that they offer higher yields than government bonds or other similar types of fixed-income securities. This is because corporate bonds are typically riskier than government bonds, which are backed by the federal government’s ability to tax and print money. In addition, corporate bonds are not tax-exempt like municipal bonds, which means that investors have to pay taxes on the interest income earned from corporate bonds.
Additionally, corporate bonds can vary on:
- Maturity: Term lengths for corporate bonds typically range from 1 to 30 years. Short-term bonds range from 1 to 3 years, medium-term bonds range from 4 to 10 years, and long-term bonds mature more than a decade later.
- Interest payments: Fixed-rate corporate bonds will pay investors a fixed interest rate until maturity, whereas floating-rate bonds are tied to a specific index and mirror the movement of that index. Zero-coupon bonds are sold at a discount and do not make regular interest payments.
- Credit rating: When corporations want to issue bonds, they must undergo a review by a rating agency such as Fitch, Moody’s, or Standard & Poor’s. Investment-grade bonds are of higher quality, while non-investment-grade bonds carry more risk.
Municipal bonds, also known as munis or muni bonds, are debt securities issued by governmental entities, including states, cities, and other local governments to finance public projects such as schools, hospitals, and infrastructure. Similar to corporate bonds, you can make money from munis by collecting interest payments on a set schedule.
One of the main advantages of investing in municipal bonds is their tax-exempt status. Interest income earned from munis is generally exempt from federal taxes and may also be exempt from state and local taxes in some circumstances. This tax-free feature makes municipal bonds an attractive option for investors seeking to minimize their tax liabilities.
Types of Municipal Bonds
Muni bonds are classified based on their source of interest payments and principal repayments. They often get issued as either general obligation bonds or revenue bonds.
General obligation (GO) bonds are backed by the issuing municipality and secured by tax revenue. They are used to fund infrastructure improvements or public works projects like parks and playgrounds that do not generate income.
Unlike revenue bonds, which are backed by revenue from specific projects, GO bonds are not tied to any particular revenue source. Some GO bonds are additionally backed by dedicated property taxes, while others are payable from general funds. These bonds are considered the safest type of municipal bond but offer lower yields than other types of bonds.
Revenue bonds, on the other hand, areissued to finance a particular project, such as a toll road, airport, or hospital. The repayment of the principal and interest on these bonds is secured by the revenue generated by the project getting financed. In other words, bondholders are paid from the project’s revenue rather than from the issuer’s general fund.
Revenue bonds can get backed by various types of revenue streams, including sales taxes, fuel taxes, hotel occupancy taxes, and user fees. Unlike general obligation bonds, revenue bonds do not have the full faith and credit backing of municipal borrowers, so they carry a higher risk of default, though they also offer the potential for higher yields.
Which Option Is Right For You?
One key factor to consider when choosing between corporate and municipal bonds is their purpose. Corporations issue bonds to fund projects that will help them become more profitable. On the other hand, municipal bonds get issued to fund public infrastructure and projects. If you are a socially conscious investor, investing in munis can be a way to align your investment strategy with your values.
Municipal Debt vs Corporate Debt
The municipal debt markets comprise various issuers and debt instruments, which may have different bond ratings, debt structures, and yields. Each state or local government has access to the municipal bond market to raise money for public projects, such as highways and water and sewer systems.
The corporate debt markets are similar in that they are also made up of different companies that issue debt to fund new projects. A company determines how much it wants to borrow from bond investors and then issues a bond offering in that amount.
Investing in bonds is considered to be a relatively safe investment option. However, all investments carry some level of risk, and bonds are no exception. Corporate bonds are generally perceived to be riskier than municipal bonds due to the different nature of the issuers.
Municipal bonds are backed by the full faith and credit of the issuing municipality (i.e. the government’s taxing power) and, in some cases, by specific revenue streams. However, some municipal bond issuers have defaulted on their debt obligations in the past, as evidenced by the bankruptcies of Detroit and Stockton. Despite these rare cases of default, municipal bonds remain a safer investment option than corporate bonds.
The risk of investing in specific bonds is assessed through credit ratings. Bonds with higher credit ratings are considered less risky than those with lower credit ratings. Investment-grade bonds are generally safer and more reliable than speculative-grade bonds, which are perceived to have a lower credit quality and thus a higher interest rate.
Buying and Selling
When buying or selling bonds, pay attention to the bid-ask spread, which is the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask).
In general, municipal bonds do not have a live bid-offer market and may only have one dealer quoting only on the offer side. On the other hand, corporate bonds typically have multiple dealers with more narrow bid-ask spreads due to competition in the markets.
This liquidity makes it easier to buy and sell individual corporate bonds vs municipal bonds.
Corporate bond issuers issue financial disclosures more frequently compared to municipal bond issuers. Corporate bond issuers are required to report financial results every quarter, or 4x per year, and report material events through 8-K filings with the US Securities and Exchange Commission (SEC). Reviewing these disclosure documents can help you make a more informed decision. Municipal bond issuers, on the other hand, typically provide annual filings (1x per year), making it difficult to assess their financial health over a year.
If you want to maximize your after-tax returns, you’ll need to consider the tax implications of your investment choices. If you’re in a high tax bracket, municipal bonds can be better suited for your portfolio as the interest income payments are typically exempt from federal income taxes. Meanwhile, corporate bonds are subject to federal and state taxes on their interest income.
But, the tax advantages of munis may depend on where you live and how much you make when you receive the interest. For example, if you live in California, a state with high-income taxes, and are in a high tax bracket, you may benefit from tax-exempt municipal bonds. If you live in a state without income taxes, such as Florida, and have limited income, you will not benefit as much from tax-exempt municipal bonds.
Use a tax-equivalent yield calculator to compare the after-tax yield of purchasing municipal bonds and corporate bonds. This calculation accounts for your tax bracket and the tax-exempt status of municipal bond interest income to determine the taxable yield required on a corporate bond to provide the same after-tax income as a municipal bond. In general, the higher your tax bracket, the more advantageous municipal bonds become.
However, note that municipal bond interest income may be subject to the alternative minimum tax (AMT) in some cases, which can reduce the tax benefits of these bonds. Additionally, be aware of the potential impact of changes in federal income tax policy on the value of their municipal bond holdings.
Risk to Return Ratio
The risk-to-return ratio gets commonly used to evaluate an investment’s performance. It compares the level of risk you take to the potential returns that can be gained from that investment. Generally, higher returns come with higher risk, while lower-risk investments usually generate lower returns.
For municipal bonds, the risk-to-return ratio is generally lower than that of corporate bonds. Municipal bonds are a relatively safe investment with a low risk of default, making them a good option if you are looking for capital preservation. However, due to their low-risk profile, municipal bonds generally offer lower returns than corporate bonds.
Corporate bonds have a higher risk profile than municipal bonds and can potentially generate higher returns. As previously mentioned, there is a wide range of corporate bond credit profiles so investors can select bonds suited to their risk tolerance and investment return objectives. However, due to their higher risk profile, corporate bonds have a higher risk-to-return ratio than municipal bonds.
Liquidity refers to the ability of an asset or security to be bought or sold in the market quickly and without significantly affecting its price. It measures how easily and quickly an investor can convert an asset into cash without incurring a significant loss of value.
Municipal bonds are generally less liquid than corporate bonds with comparable ratings due to their lower daily trading volume. The bid-ask spread can also impact the liquidity of municipal bonds, with even a small spread substantially reducing returns. Investors looking to invest in municipal bonds can consider municipal bond mutual funds or ETFs but must be careful of high load fees or bid-ask spreads, especially for low-volume ETFs.
The Bottom Line
Both municipal and corporate bonds can offer you a reliable income source without the volatility of the stock market. But before deciding on either investment, consider your risk tolerance and financial goals first. If you are looking for higher returns, the stock market may be more suitable for you. But, if you want less risky investments and a stable source of income, then bonds may be better suited for you.
Whether you decide to invest in corporate bonds or municipal bonds, remember that stocks have outperformed both options over time. If you’re looking for a more efficient way to grow your wealth, stocks might be a better fit. But if you want to generate a reliable stream of income while minimizing risk, corporate and municipal bonds could help you achieve that goal.