Municipal Bonds vs. Corporate Bonds: 2024 Comparison

There are several factors you should take into account when making a decision to buy either corporate bonds or municipal bonds.

Here’s how corporate and municipal bonds compare.

One of the first details you should look into before purchasing a bond or any other debt instrument is the quality of the issuer. Bond issuers will have different credit ratings, meaning that when you invest in the securities they’ve made available, you’ll be taking on credit risk.

There are two agencies that provide bond issuer credit ratings: Moody’s and Standard & Poor’s.

• Moody’s rating scale ranges from C to AAA, with AAA being the best possible rating.
• Standard & Poor’s follows a scale ranging from D to AAA, with AAA also being the best possible rating.

Higher ratings mean the bond is generally at lower risk of the issuer defaulting. After all, if the entity that issues the security fails to meet its obligations, those who invest in it stand to lose.

Corporate bonds are issued by corporations, and every corporation is different. Some make more money than others, some are managed by better management teams, and some will fulfill their obligations consistently while others fail.

Compared to municipal bonds, instruments issued by corporations come with a higher default risk, making it especially important to pay attention to how rating agencies rate the bond in question before you invest.

Any time you make money — whether from a side hustle, income from your day job, or investment returns — you typically have to pay taxes.

However, not all income is taxed equally. Here are the tax implications you’ll need to consider when deciding whether to invest in corporate or municipal bonds.

Bonds issued by corporations are often called taxable bonds because earnings generated through these investments will be susceptible to both federal income tax and state income tax at the general income tax rate. The exact rate you’ll pay on your returns depends on your tax bracket.

Gains generated through investments in municipal bonds are always tax exempt on the federal level and are often tax free on the state level as well. The tax exemption is essentially a “thank you” from both federal and local governments for using your investment dollars to invest in projects that support your community.

While in the vast majority of instances, munis are exempt from state and local taxes, there are some cases in which this is not true. For example, if you purchase a municipal bond offered by a municipality other than the one in which you reside, your local authorities may choose to tax returns on that bond at the standard local income tax rate.

For example, if you live in New York City and you invest in a municipal bond issued by a government body in Florida New York City may charge you its normal local tax rate on the returns generated through that investment.

Returns on bonds are known as yields, and they vary wildly from one to another depending on the credit of the issuing entity, the maturity date of the bond, and other factors.

Generally speaking, here’s how yields compare between corporate and municipal bonds:

Local governments are highly trusted entities that are known for maintaining excellent credit. On the other hand, corporations will vary wildly in financial strength and creditworthiness.

Because corporations are usually less creditworthy than governments, bonds issued by corporations generally offer higher interest rates. After all, if the yields on corporate bonds were the same as the yields on government bonds, nobody would lend to riskier corporations. Who would want to buy a bond from a corporation when the same returns can be generated by investing in lower-risk munis?

Bonds issued by the government come with a lower default risk and therefore are the safer option for investors. However, when investing, safer options generally provide lower returns, and municipal bonds are no exception.

The extremely low default risk is considered in the pricing of these bonds, resulting in lower interest rates, smaller interest payments, and lower overall returns.

That is, until you account for taxes. For example, a high income earner may find that investing in municipal bonds is a better fit because they are exempt from state and federal taxes. By contrast, much of the returns on corporate bonds would be erased by taxes for an investor in the highest tax bracket.

Liquidity should always be a consideration for investors, whether they’re investing in bonds or any other asset. Liquidity refers to the ease or difficulty of converting an investment back into cash if desired.

Investors will find it difficult to convert bonds with low levels of liquidity into cash prior to their maturity dates, while bonds with high levels of liquidity are easy to offload and turn into spendable money on demand.

While any form of bond can be sold on a secondary market, for a bond to be sold, there must be a buyer. In some cases, investments in high-risk bonds and other bonds issued by corporations may become illiquid if no other investors are interested in purchasing them.

Moreover, bond liquidity decreases in general in times of economic and market positivity. During bull markets, investors tend not to want their money tied up in fixed-income assets, instead focusing on the larger potential for returns offered by stocks.

The municipal bond market is very active, with these bonds often being easier to offload than bonds issued by corporations. That’s because muni bonds are issued by entities that are all but guaranteed to cover their obligations while providing tax benefits, making them attractive investments for high income earners.

Corporations may be looking to raise money for a wide variety of reasons. Some of the most common are:

• Working Capital. It costs money to make money, and running a business can be a very expensive endeavor. In some cases, corporations will have their money tied up in inventory, new equipment, and other assets necessary to keep it moving in the right direction and need working capital for general purposes. Companies can issue bonds as a way to raise cash for their operational needs today by promising to repay investors in the future.
• Acquisitions. Companies often acquire one another, merging two companies into one in transactions where the sum of all parts has a greater value than the original assets. However, acquisitions are expensive business, and corporations often need additional funding to execute merger and acquisition agreements.
• Research. Research and development are major expenses for just about every publicly traded company on the market today. In some cases, corporations will issue bonds in order to fund this research.

The vast majority of bonds issued by government agencies are issued to fund public projects.

For example, when a major thoroughfare is riddled with potholes or your county’s library is in need of repair, governments often issue bonds in order to cover the costs associated with these projects. Governments can repay investors either through revenue generated by the project they fund or through tax revenues.

Municipal Bonds vs. Corporate Bonds: Which is Best for You?

As you can see above, there are several reasons to invest in both types of bonds, with each having its own list of pros and cons. As with any other investment vehicle, each type of bond will be suitable for different investors with different goals.

Bonds issued by corporations are best suited for bond investors who have a relatively low income tax burden and are looking to generate larger gains out of their safe-haven investments.

These bonds are best suited for investors who:

• Are In a Low Tax Bracket. Returns from bonds issued by corporations are taxed at the standard income tax rate, which varies wildly depending on the amount of money you earn on a regular basis. As your tax rate increases, bonds issued by corporations become less attractive than tax-exempt munis.
• Are Willing to Accept Higher Levels of Risk. Based on historical default rates, corporations are nearly twice as likely to default on bond obligations than governments. As a result, corporate bond investors should be comfortable with a higher level of risk.
• Want to Generate Larger Returns. Due to the higher risk associated with bonds issued by publicly traded companies, these bonds come with higher yields than bonds issued by governments.

Municipal bonds are worth considering if you’re an investor with a generally low risk tolerance, you’re a high income earner and tax implications mean quite a bit to you, or you’re interested in funding public projects with your safe-haven investing dollars.

These bonds are best suited for you if:

• You’re In a High Tax Bracket. High-income earners are taxed at a higher rate. Because bonds issued by the government are generally tax-free investments, they are well suited for investors who have a relatively high tax burden, acting not only as safe havens, but also tax havens.
• You Have a Low Risk Tolerance. Municipal bonds are about as safe as investments come. Most local governments have never defaulted and enjoy a high credit rating; investments in these entities are very unlikely to result in default.
• You’re Looking For a Store of Value. Investments in bonds issued by the government are a great store of value, which is what makes them so attractive as safe-haven investments. Even in times of economic concern, these bonds are known to generate returns rather than losses.
• You’re Interested in Funding Public Projects. Government bonds are used to fund public projects that improve conditions for the community around you. Not only are these investments capable of generating returns and stability, there’s a feel-good effect involved in making these investments.

If you aren’t in the uppermost income tax brackets, have a moderate tolerance for risk, and are looking to generate greater diversification across your safe-haven investments, you might invest in a mix of corporate and municipal bonds.

This approach offers you a balance of the larger gains from corporate bonds and the tax benefits from munis.

Investors who would benefit most from a mix between the two:

Deciding between corporate and municipal bonds is a decision that should be based on your comfort with risk and your needs for yield and liquidity from your safe-haven investments

It’s also important to consider your returns from a tax perspective. Compare the yields on bonds issued by corporations to those on available munis to make sure the increased returns aren’t outweighed by the taxes you’d pay on your gains.

As is always the case, investors should take the time to research the bonds they’re investing in, considering historic returns, the issuer of the bond, and where the money they’re investing is going. By doing your research before making your investment, you’ll rest assured that they fall in line with your goals.