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Corporate Bonds vs. Municipal Bonds: What Investors Should Know

Key Points
  • The markets for corporate and municipal bonds are very different with respect to yields, credit quality, default rates, and liquidity.

  • The type of investment account—specifically whether it’s tax-advantaged or not—matters when deciding between corporate and muni bonds.

  • Municipal bonds generally offer higher after-tax yields than investment grade corporate bonds for investors in higher tax brackets, and they typically carry higher credit ratings as well.

How do you choose between investment-grade municipal bonds and investment-grade corporate bonds? There are a variety of factors to consider.

First of all, of course, is what type of account you’re using. If it’s a taxable account, then munis would make more sense as their coupon payments are generally already exempt from federal income taxes and possibly state taxes. If it’s a tax-deferred account such as 401(k), corporate bonds could be a better fit. 

Beyond that, investors should be aware that factors such as yields, credit quality, default rates, and liquidity can differ between the two markets. Here’s what you should think about when deciding between munis and investment-grade corporate bonds.

Taxable vs. tax-advantaged accounts

As noted above, account type matters. Munis often make much more sense in taxable accounts, especially for investors in higher tax brackets. Not only are muni payments generally exempt from federal income taxes, they also aren’t subject to the 3.8% additional Affordable Care Act surcharge on high earners’ investment income.1 Bonds issued in an investor’s home state may also be exempt from state income tax, though other taxes may apply.

In contrast, corporate bonds held in taxable accounts will be taxed at the investor’s ordinary income tax rate. That’s why they generally make more sense in tax-deferred accounts. But keep in mind that distributions from a tax-deferred account will be taxed at the investor’s ordinary income rate at the time of the distribution.

After-tax muni yields tend to be higher

At first glance, yields for municipal bonds generally appear to be lower than those for corporate bonds of similar credit quality and maturity—but that’s only because they don’t reflect munis’ tax advantages. When comparing yields for municipal and corporate bonds, we recommend comparing their after-tax yields.

For example, the Bloomberg Barclays U.S. Intermediate Corporate Bond Index offers a yield-to-worst (YTW) of 2.65%, while the 7-year component of the Bloomberg Barclays Municipal Bond Index offers a YTW of 1.71%.2 But that corporate bond yield advantage starts to disappear once you factor in taxes. Assuming a 28% federal income tax rate and a 5% state income tax rate, the average muni yield is roughly the same as the average after-tax corporate bond yield. Munis typically start to look even better at higher tax rates.

Munis generally look better at higher tax rates

Source: Bloomberg Barclays, as of 6/5/17.

Note: After-tax corporates assume an additional 5% state income tax and a 3.8% tax for the 33%, 35%, and 39.6% brackets.

Munis have higher average credit ratings

Even if we focus only on the investment-grade sections of the two markets, munis tend to be more heavily concentrated in the upper tiers of the investment-grade spectrum, meaning AA ratings or above by Standard & Poor’s or Aa and above by Moody’s Investors Service. The average rating of the Bloomberg Barclays Municipal Bond Index is between Aa2 and Aa3, using Moody's ratings scale, much higher than the average A3/Baa1 ratings range for the Bloomberg Barclays U.S. Corporate Bond Index. Two-thirds of the bonds in the muni index are rated AA or AAA—the top two ratings tiers—compared to just 12% for the corporate index.3

In fact, there are only 11 issuers in the AAA component of the corporate bond index. Of those, eight are universities or health care facilities that just happen to meet the Bloomberg Barclays criteria for inclusion in the corporate index, even though universities and health care facilities are often considered municipal issuers. Otherwise, the investment-grade corporate bond market is dominated by issues in the lower rungs of the spectrum, meaning those rated A or BBB by S&P or A or Baa by Moody’s. 

So, more conservative investors, in particular, may find a larger selection of very highly rated bonds in the muni market than in the corporate market. If you're looking for highly rated corporate bonds, there isn't much to choose from. Two corporations that engage in more traditional corporate business activities —Johnson and Johnson (JNJ) and Microsoft Corporation (MSFT)—account for 90% of the AAA component of the aforementioned corporate index. With a small number of issuers holding ratings in the top two tiers, diversification becomes much more difficult. Likewise, municipal bond investors looking for lower-rated investment-grade bonds and the higher yields they offer don't have too many options.

The muni market is higher credit quality, on average, than the corporate market

Source: Bloomberg Barclays, as of 5/26/2017. Municipals are represented by the Bloomberg Barclays Municipal Bond Index. Corporates are represented by the Bloomberg Barclays U.S. Corporate Bond Index.

Note: Numbers are rounded. 

Default rates for munis have been well below those of corporates

Municipal bonds have historically defaulted less often than corporate bonds, even when breaking it down by credit rating. In fact, BBB-rated municipal bonds have defaulted less frequently than the corporate bonds that are generally considered the most conservative—those rated three notches higher at AAA. This is generally due to municipalities having a natural monopoly on the residents they serve. For example, residents are generally limited to only one water utility district, which means that district doesn’t have to compete for customers like corporations do. Municipal issuers also generally exhibit less business risk than corporations do.

Default rates for munis have been well below those of corporates

Source: Moody’s, “US Municipal Bond Defaults and Recoveries, 1970-2015,” as of 5/31/16.

Note: Moody’s cumulative default rates calculated from marginal default rates, which represent the probability that an issuer that has survived through a particular date will default over the next time interval (10 years in this case). Default rates only include bonds rated by Moody’s. Past performance is no indication of future results.

Corporate bonds tend to be more liquid

Liquidity is a measure of how easy it is to sell a security without suffering substantial transaction costs or losses. If you need to sell a comparatively illiquid security, the chances are generally higher that you'll have to slash prices to attract a buyer.

Munis are generally less liquid than investment-grade corporate bonds because muni issues are often smaller and they may trade less often than corporate bonds. For example, the average daily trading volume in the corporate bond market was between 2.5 and 3 times the daily trading volume in the muni market from 2014 through 2016, according to the Securities Industry and Financial Markets Association (SIFMA).4

If you’re concerned about liquidity in the muni market, stick with larger, higher-rated issuers when possible.

What to do now

The markets for investment-grade corporate and municipal bonds are very different with respect to yields, credit quality, default rates, and liquidity. Municipal bonds tend to make more sense in taxable accounts for investors in tax brackets as low as 28%, where muni yields are roughly in-line with the average after-tax corporate bond yield, in addition to the benefit of having higher average credit ratings. In tax-advantaged accounts, investment grade corporate bonds will generally offer higher yields, but keep in mind that their credit ratings are lower, on average, and they have historically defaulted more than investment grade municipal bonds.

Next Steps

Talk to Us

To discuss how this article might affect your investment decisions:
-          Call a bond specialist at Schwab anytime at 877-908-1072.
-          Talk to a Schwab Financial Consultant at your local branch.

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