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Corporate Bonds vs. Municipals Bonds

Introduction

Deciding whether to invest in a corporate bond or a municipal bond seems like a very simple decision. If you’re in the higher tax brackets go with the muni, if you’re in the lower tax brackets stick to the corporate bond. However, below we explain three factors that are often overlooked or oversimplified by investors when trying to maximize net returns.

Overview:

Fixed income securities (interest bearing assets) can be broken down into numerous sub-categories.  Each has its own characteristics, expected return, and risks.  Let’s take a deeper look at the first major fundamental decision; taxability.  We will examine Corporate Bonds as a barometer for taxable bonds, and Municipal Bonds as a representative for tax-free fixed income.

First we will make a few assumptions that will hold true across this comparison scenario.  Both the Corporate bond and the Municipal bond have the same maturity (let’s assume 10 years).  The bonds are each ‘investment grade’, meaning the risk of default is in the lowest class. The Corporate bond is backed by a large-cap U.S. company; the Municipal backed by a U.S. county tax-generating municipality.

Argument 1:  Tax equivalent Yield
A Corporate bond with a yield of 5.0% and a Municipal bond with a yield of 3.0% cannot be compared apples to apples until we make an adjustment.  The holder of the Corporate Bond is required to pay taxes on his gains annually.  Therefore, an investor in the 40% tax bracket would collect $5.00 on every $100 bond held, but after paying taxes of 40% would only keep $3.00.  So in this scenario, the 5.0%
corporate bond is equivalent to the 3.0% Municipal bond; but only for the 40% tax bracket investor.  This is the key point to remember; two investable bonds, one is the best investment choice for one person, and the other a better choice for the second investor.

To determine the equivalent yield we adjust the rate on the corporate bond down by the amount of tax using the formula: Yield * (1 – Tax Rate)

Tax Equivalent Yields Currently:
LQD
– The most popular investment grade corporate bond ETF currently available is the LQD, by iShares.  The current Yield is 4.22%*.

What we notice is that depending on the type of municipal bond or bond fund we are considering, the suitability for an investor can be drastically different.  Overtime as well the yields for both the ‘average corporate bond’ and the ‘average municipal bond’ will seesaw back forth.  This creates a shift in suitability over time; what made financial sense last year could be inappropriate this year.

 

Argument 2:  Interest Rate Risk and Duration

A bond’s ‘duration’ is a measure of sensitivity to interest rates.  As interest rates go up bond prices go down, and vice-versa.  A second characteristic of duration is ‘by how much will bond price go down’.  The larger the duration, the larger the price movement.  Graphically we can see this similar to a see-saw.  The further out on the see-saw, the greater the sensitivity.

Now that we consider duration a measure of interest rate risk we can make an assumption about our two investments.  A corporate bond with a 5% yield and a municipal bond with a tax-equivalent 5% yield (both have the same expected return) should have the same amount of risk.  If the return is the same, but one of them had less risk then we would rationally choose the investment with the least amount of risk.

To accurately judge the relative risk of each bond let’s examine the timeline of a two year bond.  The corporate bond makes a $5 interest payment, and the municipal bond makes a $3 interest payment; equivalent investments for a 40% tax bracket investor.

What you will notice is that the investor in the corporate bond gets the ‘hold on to’ the $2 for a certain period of time.  During that period he/she is likely to reinvest it and earn a rate of return.  Receiving more money sooner actually reduces this investor’s interest rate risk. In this scenario, the ‘duration’ of the corporate bond is less, even though the bond is the same length of time and pays an equivalent return. Same return, less risk.

Argument 3:  Issuer Healt

So far we have assumed that all corporate bonds are alike and all municipal bonds are alike.  Further, we have assumed that there is no difference between the underlying entities.  This would be a huge oversight in non-theoretical investing.

Would you rather own Apple, or a municipal county in Southern California?

This may be a flawed comparison, but the point should be obvious.  Large U.S. corporations have revenue generating capabilities. They have products that we as consumers and other businesses demand.  On the other hand, municipalities are limited in their ability to generate revenue through taxation.  If they wish to increase revenue they must raise tax rates.  At some point a higher tax rate can actually equate to lower revenue; think about that scenario for a moment.

At this argument in the conversation we need to ask which entity, corporations or municipalities, is most likely to not be able to pay back their bond obligation.

In summary, we need to consider three effects when making a decision between corporate bonds and municipal bonds.  While on the surface they may be comparatively similar, the true risk and true return potential can often be quite different.

Conclusion
All in all, when you’re deciding between tax & tax-free bonds there is a lot more to consider than just your tax bracket. Looking at these three factors will allow you to make a more educated decision when considering your incomes tax implications.

 

Bonds are subject to market and interest rate risks if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investors yield may differ from the advertised yield. Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other states and local taxes may apply. If sold prior to maturity, capital gains tax could apply.

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