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Taxes, Bonds, Credit Ratings: What Should Bond Investors Know?

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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.

Important Disclosures
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. Please note that this content was created as of the specific date indicated and reflects the author’s views as of that date. It will be kept solely for historical purposes, and the author’s opinions may change, without notice, in reaction to shifting economic, market, business, and other conditions.
Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request.
Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.
Schwab Center for Financial Research (“SCFR”) is a division of Charles Schwab & Co., Inc.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.
Tax-exempt bonds are not necessarily suitable for all investors. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the alternative minimum tax. Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.
This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.
Diversification strategies do not ensure a profit and do not protect against losses in declining markets.
Investing involves risk including loss of principal.
Definitions
The Bloomberg Barclays U.S. Corporate Bond Index covers the U.S. dollar (USD)-denominated investment-grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P and Fitch ratings services. This index is part of the Bloomberg Barclays U.S. Aggregate Bond Index (Agg).
The Bloomberg Barclays U.S. Municipal Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed tax exempt bond market. The index includes state and local general obligation, revenue, insured and pre-refunded bonds.
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