Corporate and muni bonds currently offer similar tax-equivalent yields, but there are important differences between the two markets in terms of credit ratings and liquidity.
Average credit ratings for muni bonds tend to be higher, but the corporate bond market tends to have more liquidity.
If you're looking for higher yields and you're planning to hold the investments in tax-advantaged accounts, you'll typically have more to choose from in investment-grade corporate bonds. If you're looking for higher credit ratings and holding your bonds in a taxable account, munis often make more sense.
The municipal bond market is currently offering after-tax yields comparable to corporate bonds, but with less credit risk. Is it time for traditional corporate bond investors to take a second look at muni bonds?
Perhaps—but keep in mind that munis may have lower liquidity, meaning they may not be as fast or easy to sell as corporate bonds. Also, if you're investing in a tax-advantaged account and are willing to take a bit more credit risk, corporate bonds may still be a better option.
The yield advantage
If you invest in traditional corporate bonds due to the higher yields they offer, make sure you're taking taxes into account because municipal bonds can offer comparable or even slightly higher yields on an after-tax basis.
While corporate bonds typically offer higher yields than municipal bonds, interest earned on tax-exempt muni bonds is generally free from federal income tax—although munis can carry tax consequences. (For instance, the income may be subject to the Alternative Minimum Tax, capital appreciation from discounted bonds may be subject to state or local taxes, and capital gains are not exempt from federal income tax.)
It's important to look at the tax-equivalent yield. This calculation converts the yield on a tax-exempt security into the equivalent yield for a taxable security, and can be used to compare taxable and tax-exempt investments.1
Yields are comparable after taxes
Source: Barclays, as of 4/23/2015. Barclays U.S. Corporate Intermediate Bond Index and Barclays Municipal Intermediate Bond Index. Tax equivalent yield assumes a 25% federal tax bracket and does not take into consideration state or local taxes.
For example, the Barclays U.S. Corporate Intermediate Bond Index offered a yield-to-worst (YTW) of 2.28% as of April 24, compared to 1.74% for the Barclays Municipal Intermediate Bond Index.2 For an investor in the 25% tax bracket, the tax-equivalent yield on the muni index is actually 2.32%—slightly higher than the yield of the corporate index.
Comparing yields by credit rating shows how competitive after-tax muni yields are versus corporates. While the taxable equivalent yield for AAA-rated munis lags that of corporate bonds, it exceeds corporate yields for bonds rated AA and below.
Comparing municipal bond yields to corporate bond yields
Source: Barclays, as of 4/23/2015. Credit rating components of the Barclays Municipal Bond Index and the Barclays U.S. Corporate Bond Index. After-tax yield assumes a 25% federal tax bracket and does not take into consideration state or local taxes.
Wide discrepancy in credit ratings
While after-tax yields of munis may be comparable to corporate bonds, the credit ratings of the two types of bonds are not so comparable. That's because municipal bonds tend to be concentrated in the upper tiers of the investment-grade ratings range, while corporate bonds generally occupy the lower rungs.3
Close to two-thirds (62%) of the Barclays Municipal Bond Index is made up of bonds with ratings of AA or higher, with only 5% of the index carrying BBB ratings. Investment-grade corporates are much more bottom heavy, with about 90% of the Barclays U.S. Corporate Bond Index made up of bonds rated A or BBB. Due to its top-heaviness, the average rating of the municipal bond index is between Aa2 and Aa3, using the rating scale from Moody's Investors Service, much higher than the average A3/Baa1 rating for the corporate bond index.
Corporate bonds with the highest rating of AAA only make up 1% of the index, as many investment-grade issuers have been downgraded over the years. Today, only three U.S. corporations carry the highest credit rating of AAA/Aaa, according to Standard & Poor's and Moody's Investors Service: Johnson & Johnson Co., Microsoft Corp., and ExxonMobil Corp.
If you're looking for highly rated corporate bonds, there isn't much to choose from. With a small number of issuers holding ratings in the top two tiers, diversification has become 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 either.
So if you're looking for high-rated alternatives to Treasury bonds, municipal bonds may make more sense. If you're looking to take on a little extra credit risk to earn a higher yield, you may be better off looking at the corporate bond market, even if you're traditionally a municipal bond investor.
Lower default rates historically in muni bonds
Municipal bonds have historically defaulted less than corporate bonds, even when breaking it down by credit rating. In fact, BBB-rated municipal bonds have defaulted even less than corporate bonds rated three notches higher, at AAA.
However, the ratings agencies have recalibrated their ratings methodologies for municipal bonds starting after the credit crisis in 2008, effectively moving them up to better align with corporate credit ratings. In other words, municipal bonds that may have been rated BBB in the past may now be in the single-A range. We think this is important because default studies are backward looking, and the change in methodology may affect the default rates by credit rating. Still, we expect municipal bonds will likely continue to have lower average default rates in the future, although the discrepancy may not be as large.
Default rates for munis have been well below those of corporates
Source: Moody's "U.S. Municipal Bond Defaults and Recoveries, 1970-2013", May 2014. 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 (1 year in this case). Default rates only include bonds rated by Moody's. Past performance is no indication of future results.
Should you worry about liquidity?
Liquidity is the relative ability of a security to be sold without substantial transaction costs or reduction of value, if you need to sell. The harder it is to sell a security or the greater the loss in value resulting from the sale, the greater the liquidity risk. Municipal bond issues tend to be smaller, on average, and may trade less often than corporate bonds, so liquidity risk can be a concern. If you’re concerned about liquidity in the muni market, stick with larger, higher rated issuers when possible.
Where are you holding the bonds?
Comparing pre-tax and after-tax yields makes sense if you're investing in a taxable account, but that may not be the case in a tax-deferred account, such as an IRA or 401(k).
If the yield and credit risk of corporate bonds meet your needs, they may be more appealing in tax- deferred accounts. Interest income from corporate bonds isn't subject to federal income taxes if held in such accounts, whereas it's taxed at the investor's ordinary income tax rate in a taxable account. However, distributions from a tax-deferred account will be taxed at the investor’s ordinary income rate at the time of the distribution.
In taxable accounts, municipal bonds often make much more sense—especially for investors in higher tax brackets, since their income from the bonds will likely be tax free at the federal level. In addition, investors with taxable income above $200,000 (single filers) and $250,000 (married filing jointly) also pay a 3.8% additional Affordable Care Act (ACA) surcharge on all investment income. Interest on tax-exempt municipal bonds is not subject to the ACA surcharge. Interest on bonds issued in your home state may also be exempt from state income tax, though other taxes may apply.
What to do now
Despite the term "investment grade," the markets for corporate and municipal bonds are very different with respect to credit quality and default rates. If you're looking for higher yields in the lower rungs of the investment-grade market, especially if you're planning to hold the investments in tax-deferred accounts, the dollar amount outstanding in the market is larger with investment-grade corporate bonds, even though there are more municipal issuers. In taxable accounts, though, munis often make more sense, especially if you're looking for after-tax yield with higher credit ratings.
1 The formula for tax-equivalent yield (TEY) is the tax-free yield/(1-tax rate).
2 As of 4/23/2015. Yield-to-worst is the lower of the yield-to-worst or yield-to-call. It's the lowest yield an investor will receive, barring default. Average durations of the Barclays Municipal Intermediate Bond Index and the Barclays U.S. Corporate Intermediate Bond Index are 4.88 and 4.46, respectively. 3 Investment-grade securities are those with a credit rating of BBB- or Baa3 or above by Standard and Poor's and Moody's Investors Service, respectively.
3 Investment-grade securities are those with a credit rating of BBB- or Baa3 or above by Standard and Poor’s and Moody's, respectively.
Talk to Us
To discuss how this article might affect your investment decisions:
- Call Schwab anytime at 800-942-9084.
- Talk to a Schwab Financial Consultant at your local branch.