RANDY FREDERICK: With tax reform top of mind, many investors may be wondering how fixed-income investments might be impacted. Collin Martin, a fixed- income strategist at the Schwab Center for Financial Research, joins me for the June 22nd Schwab Market Snapshot to discuss some basic tax issues that bond investors should be aware of. Welcome back, Collin.
COLLIN MARTIN: Hi, Randy. Thanks for having me back.
RANDY: So, Collin, I know you recently published an article that talks about the differences between investment-grade corporate bonds and municipal bonds. So can you share some of the details with us?
COLLIN: Investment-grade corporate and municipal bonds are often what we consider core bond holdings, but sometimes the basic similarities and differences tend to be overlooked a little bit. So before we get to the ins-and outs, we think it’s best to start with what type of account are these investments going into.
For corporate bonds, we think they make the most sense in tax-advantaged accounts, like IRAs or 401(k)s. Because their higher yields can grow tax-free. Now, keep in mind, that distributions from those types of accounts are taxed at the time of distribution.
Now, municipal bonds, on the other hand, tend to make more sense in taxable accounts for high-income earners because their interest payments are generally exempt from federal income taxes. And depending on the investor’s home state, potentially exempt from state and local taxes, as well.
Now, when we want to compare the yields of the two we want to level the playing field and we want to see what the after-tax yield is of corporates once we take taxes into account. And what we found is that, on average, munis tend to offer higher yields at tax brackets as low as 33%. And even when you go down to the 28% tax bracket, yields are still pretty comparable. So while we think municipal bonds make sense for high-income earners, you don’t necessarily need to be in that top tax bracket to consider them.
RANDY: Okay, so there’s no question, tax treatment makes a lot of sense, but for an investor trying to decide between these two different types of bonds, credit ratings are also important. So are there any differences between the credit ratings?
COLLIN: There is a difference in credit rating. Municipal bonds tends to have higher average credit ratings than corporate bonds.
When we look at the corporate bond index, the index—the benchmark we use—is the Bloomberg-Barclay’s U.S. Corporate Bond Index. And about 88% of the issues in that index have ratings of single-A or triple-B, the lowest two rungs of the investment-grade spectrum. And looking at that a different way, that means only 12% have the top two ratings, triple-A or double-A.
And when we look at that—the municipal bond market—we see a much different picture. When you look at the Bloomberg-Barclay’s Municipal Bond Index, about two-thirds of those issuers have ratings in the top two tiers of triple-A or double-A. And, also, municipal bonds have, historically, defaulted less than corporate bonds. So if you’re a conservative investor you’re going to find more highly-rated options in the municipal bond market, and you’re also going to have issues that have, historically, defaulted less and, therefore, have less default risk.
Now, keep in mind those tax, after-tax yield comparisons I made before, those didn’t take into account those credit ratings. So for investors in the 28% tax bracket, although those yields are still comparable, if you’re in municipal bonds, you’re generally going to have higher average credit ratings.
Now, if you’re interested in corporate bonds or municipal bonds, or any fixed-income investment, for that matter, you can always call a Schwab fixed-income specialist and they can help guide you down the right path.
RANDY: Yeah, those seem like some very important considerations. Collin, thank you so much for sharing your knowledge.
Listen, if you want to read more from Collin, you can do that in the Fixed Income section of Schwab.com
. And don’t forget, you can follow me on Twitter @RandyAFrederick
. We’ll back again. Until next time, invest wisely. Own your tomorrow.