Bonds often play an important role in a well-rounded investment portfolio. While both municipal and corporate bonds can generate consistent income, they are distinct in several ways that can impact your investment strategy. Municipal bonds offer tax advantages and lower credit risk. Corporate bonds, on the other hand, may provide higher yields but come with a greater level of credit risk. A financial advisor can help you build a bond portfolio and evaluate other investment options.
What Are Municipal Bonds?
Municipal bonds are a form of debt that cities, counties and states use to pay for public projects like schools, highways, bridges and other infrastructure. The interest earned on these bonds is exempt from federal taxes, and sometimes, even state and local taxes.
As an investment, municipal bonds provide a steady stream of income through interest payments, with the principal returned upon maturity. The tax-exempt status makes them attractive to individuals in higher tax brackets, who can effectively increase their return on investment through tax savings.
Pros and Cons of Municipal Bonds
Municipal bonds are a popular investment choice due to their potential tax advantages and relative safety. However, like any investment, these fixed-income securities come with their own set of pros and cons.
Benefits of Municipal Bonds
Perhaps the most significant advantage of municipal bonds or “munis” is the tax-free interest they generate. As mentioned above, municipal bonds can also be exempt from state and local taxes if you invest in bonds issued by your home state.
Munis are known for providing a predictable and stable income stream. They’re also typically viewed to be less risky than stocks and corporate bonds. Defaults on municipal bonds are relatively rare, especially for bonds issued by financially stable municipalities. This makes them an attractive option for income-focused investors, such as retirees.
Lastly, municipal bonds can be an effective way to diversify an investment portfolio, as their performance may not always correlate with the stock market.
Disadvantages of Municipal Bonds
However, municipal bonds are not without their drawbacks. They typically offer lower yields compared to corporate bonds and stocks. This means that investors may earn less income from their investments.
And like all bonds, munis are subject to interest rate risk. If interest rates rise, the value of existing bonds can decline, potentially leaving investors who sell before maturity in the hole.
While defaults on municipal bonds are relatively rare, they can still occur, particularly with bonds issued by financially troubled municipalities. Investors should carefully assess the creditworthiness of the issuer before investing.
Finally, municipal bonds can be less liquid than other investments, making it potentially challenging to buy or sell them quickly, especially for individual investors.
What Are Corporate Bonds?
Corporate bonds are debt securities issued by companies to fund operations or growth initiatives like launching new products or entering new markets. Investors purchase these bonds, effectively lending money to the issuing company. In return, the company promises to pay periodic interest payments, typically semi-annually, and return the principal amount when the bond matures.
Unlike municipal bonds, the interest earned on these corporate bonds is subject to federal and state taxes.
Pros and Cons of Corporate Bonds
Corporate bonds are a popular investment option, offering both advantages and disadvantages for investors seeking fixed income. Here’s a closer look at both the pros and cons of investing in corporate bonds.
Benefits of Corporate Bonds
Like munis, corporate bonds provide a steady stream of income through periodic interest payments, making them attractive to income-focused investors. Compared to government bonds, corporate bonds often offer higher yields due to the added risk. This can be especially appealing when interest rates are low.
Investing in corporate bonds can also help diversify your portfolio. They have a low correlation with equities, which means they may perform differently in various market conditions, potentially reducing overall portfolio risk.
Lastly, corporate bonds come with different maturity dates. This allows investors to tailor their bond holdings to match their investment horizon and financial goals.
Disadvantages of Corporate Bonds
Despite the high return potential, corporate bonds carry a higher risk of default. This is perhaps the most significant drawback of these securities. If interest rates increase, the market value of existing bonds with lower rates decreases, resulting in potential losses.
And like munis, corporate bond prices are also sensitive to changes in interest rates. As rates increase, the value of existing bonds can fall. When this happens, investors who sell before maturity can suffer capital losses.
The creditworthiness of the issuing company is also crucial. Lower-rated or “junk bonds” have a higher risk of default, so investors must assess credit ratings carefully.
Major Differences Between Municipal and Corporate Bonds
Several key differences exist between municipal and corporate bonds. The clearest distinctions are the exemption of municipal bond income from federal tax and the higher yield potential of corporate bonds. Here are six key things you should consider:
- Issuer and purpose: Municipal bonds are issued by state or local governments to fund public projects, such as infrastructure development or schools. Corporate bonds are issued by corporations to raise capital for various business purposes, such as expansion or debt refinancing.
- Risk profile: Municipal bonds are generally considered less risky than corporate bonds. They are backed by the issuer’s ability to collect taxes or user fees. Corporate bonds carry a higher degree of risk since they depend on the financial health of the issuing corporation.
- Taxation: Interest income from municipal bonds is often tax-exempt at the federal level and may also be exempt from state and local taxes if the investor resides in the issuing state. Interest income from corporate bonds is typically subject to federal income tax and may also be subject to state and local taxes.
- Yields: Municipal bonds generally offer lower yields when compared with corporate bonds of similar maturities.
- Liquidity: Municipal bonds may have lower liquidity when compared with corporate bonds, as they are traded less frequently in the secondary market.
- Market perception: Municipal bonds are often viewed as a stable and conservative investment option. Corporate bonds, on the other hand, can be seen as a way to potentially earn higher returns but come with higher risk.
Which Option Makes the Right Investment?
The decision between municipal and corporate bonds should align with your financial goals, risk tolerance and tax situation. If you’re in a higher tax bracket, municipal bonds may provide tax advantages that make them more appealing. Conversely, if you’re in a lower tax bracket, corporate bonds with higher yields might be a better fit.
If you prioritize safety and are risk-averse, municipal bonds may be the better choice due to their historically lower default rates. However, if you are willing to take on more risk for potentially higher returns, corporate bonds may be suitable.
Consider your investment time horizon, as well. Municipal bonds are often preferred for shorter-term goals. However, both types of bonds can help you diversify your portfolio and spread risk. Including both municipal and corporate bonds in your portfolio may help you achieve a balance between safety and potential returns.
Understanding the difference between municipal and corporate bonds is key to diversifying your investment portfolio. The choice between the two, in reality, often boils down to individual tax circumstances, risk tolerance and investment goals. Therefore, remember that when dealing with complex financial instruments like bonds, it could be beneficial to seek the guidance of a financial advisor to ensure that your choices align with your overall financial plan.
Portfolio Management Tips
- Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- One of the keys to a successful portfolio is aligning your allocation with your risk tolerance. SmartAsset’s free asset allocation calculator can help you do this by selecting a profile.
Photo credit: ©iStock.com/Dean Mitchell, ©iStock.com/Dzmitry Skazau, ©iStock.com/designer491