How do you choose between corporate and municipal bonds? Both have characteristics that can be useful in your portfolio, depending on your goals and circumstances, but they’re not right for every situation.
First, start with the type of account you’re using:
- Interest income from municipal bonds is generally exempt from federal and potentially state income taxes, so munis can make more sense than corporate bonds in taxable accounts, like a brokerage account, but it will depend on a few factors that we’ll discuss below.
- For tax-deferred accounts, such as an individual retirement account (IRA) or 401(k), corporate bonds generally make more sense.
Beyond that, you should be aware of factors such as yields, maturity, and credit quality, as they can differ between the two markets and influence which is more attractive. Here’s what you should consider when deciding between munis and investment-grade corporate bonds.
1. What account type are you investing in?
As noted above, if it’s a tax-deferred account, such as an IRA or 401(k), then corporate bonds will likely make more sense than munis. A key benefit of municipal bonds is that their coupon payments are generally exempt from federal and potentially state income taxes, and they aren’t subject to the 3.8% tax on high earners’ investment income.
For tax-advantaged accounts, however, that benefit goes away, because earnings aren’t taxed until the time of distribution (usually at a later date). As a result of the tax benefits, munis tend to pay a lower rate of interest relative to corporate bonds of similar maturity and credit quality, so holding municipal bonds in a tax-deferred account likely means you’re missing out on higher yields that corporate bonds can provide.
One caveat is taxable municipal bonds. Their interest income is subject to federal and state taxes, just like corporate bonds. Corporate bonds historically have yielded more than taxable municipal bonds, but there have been times—like June 2020 through January 2021—where taxable munis yielded more than corporate bonds. In instances such as these, taxable munis should be considered along with corporate bonds for tax-deferred accounts.
Corporate bonds historically have yielded more than taxable munis
Source: Bloomberg Intermediate-term Taxable Municipal Bond Index and Bloomberg Intermediate Term Corporate Bond Index, as of 9/7/2021. The chart is truncated at +80 for visual purposes. The maximum value was 265 on 3/23/2020. One basis point (BPS) is equal to one one-hundredth of one percent, or 0.01%. Past performance is no guarantee of future results.