When building a balanced investing portfolio, you’ll want to include bonds in your asset allocation. These assets provide safety and stability, offering relatively slow growth and reliable returns.
As you begin to research which bonds to buy, you’ll realize there are several different types of bonds, with the two most common being corporate bonds and municipal bonds.
What’s the difference, and what are the pros and cons that come along with investing in each type of bond? Let’s review the basics of bonds and then look at the two types side by side to help you choose which is right for you.
What Are Bonds?
Bonds are a form of fixed-income security known for providing a relatively safe store of value that are often used to offset risk in a well-balanced investment portfolio. Bonds are essentially loans given to the issuer by the investor, making them a debt instrument.
Investors make money by investing in bonds in one of two ways:
- Coupon Rates. The most common return on investment derived from bonds is known as the coupon rate, or the interest rate on the bond. As with many other types of loans, the investor pays the full face value of the bond upon purchase and receives interest payments until the maturity date of the bond, at which point their initial investment is returned to them.
- Premium. In some cases, bonds can be purchased at a discount to their face value. When the bond matures, the investor receives the full face value of the asset, providing a return on investment. For example, an investor may purchase a $1,000 bond for $950. Once the bond matures, the full $1,000 is repaid, leaving the investor with $50 in profits.
What Are Municipal Bonds?
Municipal bonds are commonly referred to as muni bonds, or simply munis. These bonds are issued by local governments, generally on the state or county level, and should not be confused with Treasury bonds, which are issued on a federal level and backed by the full faith and security of the U.S. federal government.
There are two common types of munis on the market today:
- Revenue Bonds. Revenue bonds are bonds issued by a municipality that are backed by the revenue generated from a specific project. For example, local municipal governments often issue water and sewer bonds, which are paid back with the revenue collected by the local government for the provision of clean drinking water and sewage services to residents within the locality.
- General Obligation Bonds. General obligation bonds aren’t backed by any project revenue. Instead, they’re backed by the taxing authority of the issuers at hand and paid back with tax dollars paid for local income taxes, sales taxes, property taxes, or any other tax revenue received by the local authorities that issued the muni.
What Are Corporate Bonds?
Rather than being issued by a local, state, or federal government, these bonds are debt instruments issued by corporations; they act as loans made from the bondholder to the corporation that issued the security. There are different categories of corporate bonds, including:
- Collateral Trust Bonds. Collateral trust bonds use collateral other than real estate to secure the bond. For example, a company may secure bond issues with shares of stock, bonds, or other securities.
- Debenture Bonds. Debenture bonds are corporate bonds that aren’t secured by any collateral. These bonds are generally issued by corporations with the best credit ratings, because companies with poor credit won’t be able to attract investors to these securities.
- Convertible Debentures. Convertible bonds give the investor the ability to convert the bond into a specified number of shares at a specified time. For example, a company may sell a convertible bond that may be converted into 25 shares of its common stock after two years. Because these bonds can be converted into common stock, they are generally more attractive to investors, but it’s a tradeoff. These types of bonds generally come with low coupon rates.
- Guaranteed Bonds. Guaranteed bonds are guaranteed not only by the corporation that issues them, but also by a second company. This greatly reduces the level of risk because another company guarantees to step in and fulfill the obligations of repaying the bond if the original borrower defaults.
- High-Yield Bonds. High-yield bonds, also known as junk bonds, are bonds that have been rated by rating agencies to be below investment grade. These companies generally have significantly high credit risk and must offer higher yields in order to attract investors.
Pro tip: Have you considered hiring a financial advisor but don’t want to pay the high fees? Enter Vanguard Personal Advisor Services. When you sign up you’ll work closely with an advisor to create a custom investment plan that can help you meet your financial goals.
Key Factors to Consider
There are several factors you should take into account when making a decision to buy either corporate or municipal bonds. Some of the most important of these factors include the quality of the entity issuing the bond, the tax implications, yield, liquidity, and how the money raised through the issuance of the bond will be used.
Here’s how corporate and municipal bonds compare:
Quality of Issuer
One of the first details you should look into before purchasing a bond or any other debt instrument is the quality of the issuer. Bond issuers will have different credit ratings, meaning that when you invest in the securities they’ve made available, you’ll be taking on credit risk.
There are two agencies that provide bond issuer credit ratings: Moody’s and Standard & Poor’s. Moody’s rating scale ranges from C to AAA, with AAA being the best possible rating. Standard & Poor’s follows a scale ranging from D to AAA, with AAA also being the best possible rating.
Higher ratings mean the bond is generally at lower risk of the issuer defaulting. After all, if the entity that issues the security fails to meet its obligations, those who invest in it stand to lose.
Corporate Bonds Come With Higher Default Rates
Corporate bonds are issued by corporations, and every corporation is different. Some make more money than others, some are managed by better management teams, and some will fulfill their obligations consistently while others fail.
Compared to municipal bonds, instruments issued by corporations come with a higher default risk, making it especially important to pay attention to how rating agencies rate the bond in question before you invest.
The good news is that even corporations rarely default. According to the Corporate Finance Institute, only about 0.13% of corporations that issue a bond will default.
Municipal Bonds Come With Lower Default Risk
Municipal bonds are generally an even safer bet than corporate bonds. According to ETF.com, only about 0.08% of munis end up in default. Because these bonds are issued by local governments, entities known for top-notch credit quality, and generally rated AAA by S&P Global, investors can rest assured that they will be paid as agreed in the vast majority of cases.
Any time you make money — whether from a side hustle, income from your day job, or investment returns — you typically have to pay taxes. However, not all income is taxed equally. Here are the tax implications you’ll need to consider when deciding whether to invest in corporate or municipal bonds.
How Corporate Bonds Are Taxed
Bonds issued by corporations are often called taxable bonds because earnings generated through these investments will be susceptible to both federal income tax and state income tax at the general income tax rate. The exact rate you’ll pay on your returns depends on your tax bracket.
How Municipal Bonds Are Taxed
Gains generated through investments in municipal bonds are always tax exempt on the federal level and are often tax free on the state level as well. The tax exemption is essentially a “thank you” from both federal and local governments for using your investment dollars to invest in projects that support your community.
While in the vast majority of instances, munis are exempt from state and local taxes, there are some cases in which this is not true. For example, if you purchase a municipal bond offered by a municipality other than the one in which you reside, your local authorities may choose to tax returns on that bond at the standard local income tax rate.
For example, if you live in New York City and you invest in a municipal bond issued by a government body in Florida New York City may charge you its normal local tax rate on the returns generated through that investment.
Returns on bonds are known as yields, and they vary wildly from one to another depending on the credit of the issuing entity, the maturity date of the bond, and other factors.
Generally speaking, here’s how yields compare between corporate and municipal bonds:
Corporate Bonds Generally Have Higher Yields
Local governments are highly trusted entities that are known for maintaining excellent credit. On the other hand, corporations will vary wildly in financial strength and creditworthiness.
Because corporations are usually less creditworthy than governments, bonds issued by corporations generally offer higher interest rates. After all, if the yields on corporate bonds were the same as the yields on government bonds, nobody would lend to riskier corporations. Who would want to buy a bond from a corporation when the same returns can be generated by investing in lower-risk munis?
Munis Provide Small Gains
Bonds issued by the government come with a lower default risk and therefore are the safer option for investors. However, when investing, safer options generally provide lower returns, and municipal bonds are no exception.
The extremely low default risk is considered in the pricing of these bonds, resulting in lower interest rates, smaller interest payments, and lower overall returns.
That is, until you account for taxes. For example, a high income earner may find that investing in municipal bonds is a better fit because they are exempt from state and federal taxes. By contrast, much of the returns on corporate bonds would be erased by taxes for an investor in the highest tax bracket.
Liquidity should always be a consideration for investors, whether they’re investing in bonds or any other asset. Liquidity refers to the ease or difficulty of converting an investment back into cash if desired.
Investors will find it difficult to convert bonds with low levels of liquidity into cash prior to their maturity dates, while bonds with high levels of liquidity are easy to offload and turn into spendable money on demand.
Corporate Bonds Are Often Less Liquid
While any form of bond can be sold on a secondary market, for a bond to be sold, there must be a buyer. In some cases, investments in high-risk bonds and other bonds issued by corporations may become illiquid if no other investors are interested in purchasing them.
Moreover, bond liquidity decreases in general in times of economic and market positivity. During bull markets, investors tend not to want their money tied up in fixed-income assets, instead focusing on the larger potential for returns offered by stocks.
Municipal Bonds Are Highly Liquid
The municipal bond market is very active, with these bonds often being easier to offload than bonds issued by corporations. That’s because muni bonds are issued by entities that are all but guaranteed to cover their obligations while providing tax benefits, making them attractive investments for high income earners.
How Funds Are Used
Investors are becoming increasingly concerned with the way in which their investments are spent. In fact, there’s an entire movement surrounding social impact investing, or investing in assets that use your funds to make an impact for causes you care about.
So, how exactly is your money spent when you invest in these two different types of bonds?
How Corporations Use Money Raised Through Bond Sales
Corporations may be looking to raise money for a wide variety of reasons. Some of the most common are:
- Working Capital. It costs money to make money, and running a business can be a very expensive endeavor. In some cases, corporations will have their money tied up in inventory, new equipment, and other assets necessary to keep it moving in the right direction and need working capital for general purposes. Companies can issue bonds as a way to raise cash for their operational needs today by promising to repay investors in the future.
- Acquisitions. Companies often acquire one another, merging two companies into one in transactions where the sum of all parts has a greater value than the original assets. However, acquisitions are expensive business, and corporations often need additional funding to execute merger and acquisition agreements.
- Research. Research and development are major expenses for just about every publicly traded company on the market today. In some cases, corporations will issue bonds in order to fund this research.
How Municipalities Use Money Raised Through Bond Sales
The vast majority of bonds issued by government agencies are issued to fund public projects.
For example, when a major thoroughfare is riddled with potholes or your county’s library is in need of repair, governments often issue bonds in order to cover the costs associated with these projects. Governments can repay investors either through revenue generated by the project they fund or through tax revenues.
The Verdict: Should You Choose Corporate or Municipal Bonds?
As you can see above, there are several reasons to invest in both types of bonds, with each having its own list of pros and cons. As with any other investment vehicle, each type of bond will be suitable for different investors with different goals.
You Should Invest In Corporate Bonds If…
Bonds issued by corporations are best suited for bond investors who have a relatively low income tax burden and are looking to generate larger gains out of their safe-haven investments. These bonds are best suited for investors who:
- Are In a Low Tax Bracket. Returns from bonds issued by corporations are taxed at the standard income tax rate, which varies wildly depending on the amount of money you earn on a regular basis. As your tax rate increases, bonds issued by corporations become less attractive than tax-exempt munis.
- Are Willing to Accept Higher Levels of Risk. Based on historical default rates, corporations are nearly twice as likely to default on bond obligations than governments. As a result, corporate bond investors should be comfortable with a higher level of risk.
- Want to Generate Larger Returns. Due to the higher risk associated with bonds issued by publicly traded companies, these bonds come with higher yields than bonds issued by governments.
You Should Invest In Municipal Bonds If…
Municipal bonds are worth considering if you’re an investor with a generally low risk tolerance, you’re a high income earner and tax implications mean quite a bit to you, or you’re interested in funding public projects with your safe-haven investing dollars. These bonds are best suited for you if:
- You’re In a High Tax Bracket. High-income earners are taxed at a higher rate. Because bonds issued by the government are generally tax-free investments, they are well suited for investors who have a relatively high tax burden, acting not only as safe havens, but also tax havens.
- You Have a Low Risk Tolerance. Municipal bonds are about as safe as investments come. Most local governments have never defaulted and enjoy a high credit rating; investments in these entities are very unlikely to result in default.
- You’re Looking For a Store of Value. Investments in bonds issued by the government are a great store of value, which is what makes them so attractive as safe-haven investments. Even in times of economic concern, these bonds are known to generate returns rather than losses.
- You’re Interested in Funding Public Projects. Government bonds are used to fund public projects that improve conditions for the community around you. Not only are these investments capable of generating returns and stability, there’s a feel-good effect involved in making these investments.
Both Are Great If…
If you aren’t in the uppermost income tax brackets, have a moderate tolerance for risk, and are looking to generate greater diversification across your safe-haven investments, you might invest in a mix of corporate and municipal bonds. This approach offers you a balance of the larger gains from corporate bonds and the tax benefits from munis. Investors who would benefit most from a mix between the two:
- Want Higher Returns While Minimizing Tax Burden. By investing in both types of bonds, you’ll reduce your tax burden compared to corporate bond investments alone while enjoying higher earnings potential than provided by municipal bond investments alone.
- Have a Moderate Tolerance for Risk. Bonds in general — with the exception of junk bonds — are relatively safe investments. However, some assets within the class are safer than others. Mixing corporate investments into your portfolio of municipal investments will lead to a slight increase in the overall risk level across your portfolio. As an investor, you’ll have to be comfortable with that added risk in exchange for the greater returns.
- Want High Levels of Diversification. Diversification helps to reduce risk across investment portfolios. By investing in multiple assets across multiple categories, investors don’t have to fear detrimental declines should one, or even a handful, of these assets experience losses.
Deciding between corporate and municipal bonds is a decision that should be based on your comfort with risk and your needs for yield and liquidity from your safe-haven investments
It’s also important to consider your returns from a tax perspective. Compare the yields on bonds issued by corporations to those on available munis to make sure the increased returns aren’t outweighed by the taxes you’d pay on your gains.
As is always the case, investors should take the time to research the bonds they’re investing in, considering historic returns, the issuer of the bond, and where the money they’re investing is going. By doing your research before making your investment, you’ll rest assured that they fall in line with your goals.