Many people turn to bonds as a means of saving for retirement. Others use bonds as a long-term investment vehicle to fund pre-retirement goals, such as paying for a child’s wedding or paying for college tuition. And then there are those who simply wish to grow their year-to-year earnings by investing in bonds, which are typically less volatile than stocks.
When many people hear the word “bonds,” they tend to think of corporate bonds – those issued by big companies in the public eye. However, there’s a lot more to the bond market than just that. In fact, municipal bonds are another popular option for those looking to break into the world of bond investing.
While corporate and municipal bonds share many of the same features, they are, in reality, very different beasts. Understanding the difference between the two can help you decide which type of bond is right for you and aligns most closely with your financial needs and investment strategy.
A bond is a debt instrument or loan issued in order to borrow money. When you purchase a bond, what you’re essentially doing is agreeing to lend the issuer a certain amount of money for a preset period of time. Generally, in return, the borrower agrees to make interest payments at a fixed rate throughout the life of the bond. Once the term of the bond ends, the borrower is obliged to repay the principal in full.
There are some bond variations that stray from this basic model. For example, zero-coupon bonds don’t make interest payments, but instead are available for purchase at a discount off the face value. A zero-coupon bond with a face value of $10,000 and a 10-year maturity might trade today for just 60% of face value, or $6,000, which means you’d pay $6,000 up front but redeem your bond in 10 years for a payout of $10,000.
Other bond types are available. However, interest-paying bonds are the most common.
There are two ways to make money by investing in interest-bearing bonds: You can hold bonds and collect interest payments over the course of their respective terms, or you can sell your bonds at a premium before they mature. Because the value of bonds can go up or down depending on market conditions, you may be able to sell your bonds for more than what you paid for them.
Factors such as interest rates and a company’s rating or performance can impact the value of your bonds. Bonds and interest rates tend to have an inverse relationship. When interest rates go up, bond prices tend to fall – and on the flip side, lowered interest rates make bonds paying higher rates more attractive. An issuer’s rating can also influence bond prices so that when a rating goes up, so too do bond prices. Similarly, if you buy a corporate bond and the issuer releases a positive earnings statement, you might see the face value of your bond go up.
Corporate bonds are loans that are issued by corporations. Companies frequently issue bonds to pay for things such as research and development, operating expenses, and expansion. Corporate bonds are backed by the issuing company’s ability to repay what it borrows, typically through sales, operations, and assets.
Municipal bonds, or “muni bonds” for short, are loans issued by government entities, or municipalities. Municipal bonds are typically used to finance public projects such as infrastructure, road repairs, hospitals, and school systems.
These are the two most common types of municipal bonds:
- General Obligation Bonds. Called “GO bonds” for short, these are backed by the full faith, credit, and taxing power of the issuer, which is typically a city, state, county, or township.
- Revenue Bonds. These bonds are backed by the income generated by the projects they’re issued to fund.
General obligation bonds are usually considered to be safer than revenue bonds because the issuer can use any means necessary to pay back its lenders. For example, a city can raise taxes if needed in order to make scheduled bond payments.
By contrast, revenue bonds rely on income from a specific project in order to repay lenders. For example, if a city issues revenue bonds to build a new toll road, the money collected from commuters can be used to make scheduled payments to bondholders.
Revenue bonds are a bit riskier than general obligation bonds because the ability of issuers to repay bondholders is tied directly to a specific revenue stream. Unlike general obligation bonds, a municipality can’t simply tap other resources to make good on its obligations. If the project in question doesn’t generate enough revenue, the issuer in question runs the risk of defaulting, or not making payments as it’s supposed to.
Risks of Investing in Bonds
Both corporate and municipal bonds come with a degree of risk. Understanding these risks is a critical part of making a sound investment.
- Default Risk. A default is the failure of an issuing party to make payments as scheduled. A bond issuer is considered to be in default if it fails to make an interest payment or repay bondholders their principal. In fact, if an issuer is even a day late on a scheduled payment, it is considered to be in default. To minimize your risk of getting hit by a bond default, you can purchase a bond with a high credit rating. Issuers with favorable ratings are considered to be more financially stable, and are less likely to default on their obligations. If you buy a bond with a lower credit rating and higher default risk, you’re typically rewarded with a higher interest rate. Bonds that are considered safer tend to pay less because you’re assuming less risk when you buy them.
- Interest Rate Risk. When you purchase a bond, you’re locking your money into a fixed period of time, the exact length of which is determined by the specific terms of the bond. By doing so, you could lose out on the opportunity to purchase other bonds offering more favorable interest rates. The thing to remember about interest rates is that they can change over time, and that it’s possible for the same company or municipality to issue bonds at a certain rate one year, and at a higher rate a year or two down the line.
- Call Risk. When an issuer calls a bond, it redeems that bond prior to its maturity date. If a bond’s terms allow the issuer to exercise a call option, the issuer can take advantage of lower interest rates, call the bonds, and reissue them at a lower rate. If this happens to you as a bondholder you get your principal back in full – but if you want to put that money back into bonds, you’ll most likely be stuck investing in something that pays a lower rate.
For example, let’s say that you purchase a 10-year bond with an interest rate of 2%. If interest rates rise over the next few years and the same company starts issuing bonds paying 4%, your bonds are likely to lose value. If you sell them before they mature, you’re probably going to take a loss on their principal.
On the other hand, the good thing about bonds is that no matter what the market value happens to be at the time, if you hold them until their maturity date, you won’t lose any of your principal as long as the issuer doesn’t default.
Both municipal and corporate bonds follow a ratings system that allows investors to get a sense of how their issuers are faring financially. Ratings cannot protect you from interest rate risk, but they can (to an extent) protect you from default risk.
The higher the bond rating, the less likely the issuer is to default on its obligations. Corporate and municipal bonds are rated in the same fashion.
These are the three major rating agencies used to evaluate bonds:
- Standard & Poor’s (S&P)
S&P and Fitch use a similar rating system, while the Moody’s system is slightly different. Corporate or municipal bonds rated BBB- or Baa3 or higher are considered investment grade, which means they carry a low risk of default. On the other hand, bonds rated below BBB- or Baa3 are considered junk bonds, which means they’re more likely to default on their obligations.
How Corporate and Municipal Bonds Differ
Though corporate and municipal share many of the same traits, there are a number of key differences between the two.
Civic Purpose Vs. Profit
Corporate bonds are used to raise capital so that companies can continue to operate and, in turn, make money. Municipal bonds are different in that they’re used to finance public projects and keep cities, towns, and counties running smoothly.
Often, the purpose of the projects financed by municipal bonds is to enhance the quality of life for those who reside in the issuing localities. In this regard, many tend to liken municipal bonds to nonprofit organizations, in that the purpose of issuing them is not to make money, but to offer services to the public. Even toll roads and bridges, which are often funded by municipal bonds, aren’t considered to be “profitable” in the same way public companies are. While toll roads and bridges do bring in revenue, that money is often used to keep them updated and maintained – it doesn’t simply wind up in someone’s bank account.
Bond investors who are committed to community or civic investing generally choose municipal bonds over corporate bonds. Municipal bonds are frequently issued to build hospital systems, develop housing projects in under-served neighborhoods, update schools, and clean up parks and community gardens. Corporate bonds, by contrast, are often used to develop products that a company then sells for a profit.
The interest earned on corporate bonds is subject to federal, state, and local taxation. However, with municipal bonds the interest you earn is always exempt from federal taxes, and if you buy a bond that’s issued by the state in which you reside, the interest you earn may be exempt from state and local taxes as well.
Furthermore, if you buy a municipal bond that’s issued by one of the U.S. territories (such as Puerto Rico, the Virgin Islands, and Guam), the interest is also exempt at both the federal and state levels. For this reason, municipal bonds tend to appeal to those who fall into high income tax brackets.
Interest Rates and Yields
Some people use the terms “interest rate” and “yield” interchangeably, but they’re actually quite different. The interest rate is the amount of interest the bond issuer agrees to pay you, whereas the yield is the rate of return based on the current price of the bond. The only time the interest rate and yield are the same is when the bond is worth its original face value.
Let’s say you buy a bond with a $10,000 face value and a 5% interest rate. If that’s the case, you can expect $500 per year in interest.
Now let’s say that same $10,000 bond drops in price due to market conditions, and as a result its face value is just $5,000. In that case, its new yield is 10%, but the interest rate remains at 5%. Assuming the issuer makes its payments as scheduled, you still wind up getting $500 per year in interest payments, but your yield is just 5%, whereas someone who buys the bonds at their new price gets the same $500 in interest but snags a yield of 10%.
Corporate bonds, on a whole, tend to offer higher interest rates and yields than municipal bonds. According to WM Financial Strategies, the average yield on municipal bonds has been just over 4% from 2005 to 2015, while the average yield on corporate bonds has been between 5% and 7%. Going back to 1991, the average rate of return on municipal bonds was approximately 6%, compared with about 11.5% for the S&P 500 stock market index, according to this analysis.
On the other hand, municipal bonds offer tax-free interest, which helps make up for some of the potentially lost earnings in foregoing a higher interest rate. If you’re not in a particularly high tax bracket, or if you know you’ll be taking some losses on your investments in a given year (and are able to write these losses off against gains on your taxes), it might make more financial sense to invest in a corporate bond with a higher yield and pay taxes on whatever interest you earn.
To reconcile the difference between taxable corporate bond interest and tax-free municipal bond interest, you can calculate the tax-equivalent yield. This can help you determine whether taxable corporate bonds or tax-exempt muni bonds are going to be the most profitable option for you.
Online calculators are available to help you run the numbers, or, if you’re feeling brave, you can use the following formula: rm=rc (1-t) or rc=rm/(1-t)
- rm = interest rate of municipal bond
- rc = interest rate of corporate bond
- t = tax rate
Let’s say you fall into a 30% tax bracket and are looking at buying a municipal bond paying 4% interest.
- rc = 4%/(70%)
- rc = 0.0571 = 5.71%
Using the above equation, you can determine that earning 4% interest tax-free is the equivalent of buying a corporate bond with a 5.71% interest rate and paying taxes on your earnings.
Both corporate and municipal bonds come with a degree of default risk. That said, municipal bonds have historically low default rates, and according to LearnBonds, municipal bonds are 50 to 100 times less likely to default than comparably rated corporate bonds. Furthermore, according to Liberty Street Economics, S&P reported only 47 muni bond defaults between 1986 and 2011, and Moody’s reported just 71 between 1970 and 2011. By contrast, S&P reported 2,015 corporate bond defaults and Moody’s reported 1,784 during those same time periods.
If you buy a municipal bond with a strong credit rating, you’re even less likely to encounter a default. According to Invesco, since 1970 there have been no Aaa-rated municipal bond defaults, and from that point on, only 0.01% of muni bonds with an Aa rating have defaulted. By contrast, Aa-rated corporate bonds have had a default rate of 0.99% since 1970, and Aaa-rated corporate bonds have had a 0.49% default rate.
When you’re dealing with defaults, one thing you do want to keep in mind is your recovery rate, which is the extent to which bondholders end up being paid what they’re owed after an issuer defaults. Municipal bonds tend to have a much stronger recovery rate than corporate bonds. In fact, according to municipalbonds.com, the recovery rate for general obligation bonds is close to 100%, and according to Moody’s, the ultimate recovery rate for municipal bonds was about 60% from 1970 to 2013, whereas the recovery rate for corporate bonds was only 48% from 1987 to 2013.
One of the greatest barriers to entry with regard to municipal bonds is the fact that most come with minimum investment requirements. While this is also true of corporate bonds, most municipal bonds require a minimum investment of $5,000. Corporate bonds, by contrast, can typically be purchased in denominations of $1,000, making them far more accessible to the public.
The municipal bond market is only about one-third the size of the corporate bond market, which means there are far more investment opportunities out there when it comes to corporate bonds. The municipal bond market is about $3.7 trillion in size, whereas the corporate bond market has roughly $11 trillion outstanding bond issues.
When you buy bonds, you’re locked into whatever terms their contracts specify. For example, if you buy a 20-year bond, you’re locked into whatever interest rate that bond is paying over the course of 20 years. Your only way out is to sell your bonds, for better or worse.
If market conditions are good, you can make a profit by selling your bonds for more than what you paid for them. However, if market conditions are poor, or if the specific bond you’re looking to sell is undesirable due to a low credit rating, you could wind up getting less than what you paid.
Generally speaking, corporate bonds are considered to be more liquid than municipal bonds, which means you have a better chance of selling a corporate bond without taking a loss. The reason for this is that corporate bonds are actively traded on the New York Stock Exchange. Municipal bonds, on the other hand, are typically bought and sold in what’s called an over-the-counter market, which means they’re not traded on a public exchange.
If a bond is listed on an exchange, it can essentially be bought or sold at any time. Typically, though, only a small subset of municipal bonds are actively offered for sale at any given time, and what’s offered can vary significantly from day to day. Because municipal bonds are not traded on an exchange, there’s less of an opportunity to find a buyer once you decide you’re ready to sell them.
Reporting, Disclosures, and Broker Fees
Corporate bond issuers are required to publicly disclose certain information that could impact their bonds, such as financial problems or earnings. Furthermore, when corporate bonds are bought and sold, the prices they trade at must be disclosed as well.
Municipal bonds, on the other hand, don’t presently have the same disclosure requirements on both the part of issuers and brokers, so there’s less information for would-be investors to evaluate. However, steps are being taken to make the municipal bond market more transparent. On February 13, 2015, Securities and Exchange Commissioner Luis A. Aguilar issued a statement calling for changes to help make the municipal bond market more fair and accessible to individual investors.
Additionally, because municipal bonds typically aren’t purchased on an exchange, the brokers and dealers who sell them frequently charge markups that are built into the prices at which they’re offered. Furthermore, you might pay a commission, which can add to your cost and eat away at whatever profit you’re hoping to make from your investment. Though you might pay a commission on corporate bonds as well, those don’t tend to carry the same sort of markups because they’re more widely available and have pricing that’s easier to track.
While municipal bond information can be somewhat difficult to come by, the Municipal Securities Rulemaking Board‘s website is a great resource. It includes key data, such as recent trade activity and historical bond prices.
Both corporate and municipal bonds have their advantages and drawbacks. Corporate bonds frequently offer a higher potential for profit, but with that upside comes an increased default risk. By contrast, municipal bonds tend to offer lower yields than corporate bonds, but the likelihood of a municipal bond defaulting is much lower. And while the interest earned on corporate bonds doesn’t share the same tax-exempt status as that of municipal bonds, those in lower income tax brackets may be better off investing in corporate bonds with higher rates.
If you’re the type of investor who’s committed to making a social impact, you may be more inclined to put your money into municipal bonds, as they’re often used to fund public projects that improve communities and lives. On the other hand, if you don’t have a lot of money to invest and want the flexibility to sell your bonds with ease, corporate bonds may be a better option.
What type of bonds do you have in your investment portfolio? Are you happy with their performance?