Why Is Return on a Municipal Bond Lower Than a Corporate Bond?
The big difference between the interest paid by corporate bonds compared to municipal bonds is taxes. Municipal bonds are issued by state and local governments, and the interest they pay is exempt from federal income taxes. The comparison of corporate and municipal bonds requires some additional information and calculations.
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Function
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Bonds are debt instruments issued by governments and corporations. Bonds are issued with a fixed interest or coupon payments, and a maturity date several years to 30 years in the future. when the face amount of the bond will be returned to the bondholder.
The rate of interest a bond issuer must pay is based on the credit quality of the issuer and the time until the bond matures. State and local governments issue municipal bonds, which pay investors interest that is exempt from income taxes. This allows municipalities to pay a lower rate of interest than their taxable competitors for bond investor money.
Considerations
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Bond investors who are comparing corporate bonds and municipal bonds must compare the after-tax return or taxable-equivalent yield.
If an investor with a corporate bond earns $1,000 in interest and she is in the 35 percent income tax bracket, $350 of the interest must go to pay taxes, leaving the investor with only $650. The municipal bond investor who earns $650 receives a lower return, but gets to keep the whole $650. On an after-tax basis, the lower return of the municipal bond is the same as received from the corporate bond.
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Calculations
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The taxable-equivalent yield calculation is a useful tool when comparing the real returns of corporate and municipal bonds.
Take the yield of the tax-free municipal bond and divide it by one minus the marginal tax rate. If a municipal bond yields 5 per cent and the tax rate is 35 percent, divide the 5 by 1 minus 0.35, resulting in a taxable equivalent yield of 7.69 percent. The lower 5 percent yield on the municipal bond is the same return after taxes as the corporate bond paying 7.69 percent.
Considerations
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Bonds should be evaluated on more than just the yield, taxable or otherwise. Corporate bonds and municipal bonds have credit ratings issued by rating agencies such as Standard & Poor's and Moody's. Bonds are split between investment grade with a credit rating of BBB or better, and non-investment grade, high-yield or "junk bonds" that have a credit rating lower than BBB.
The municipal and corporate sectors of the bond market both have investment-grade and non-investment-grade bonds available. Junk corporate bonds are a popular, high-risk investment. These bonds have yields significantly greater than municipal bonds, even after tax considerations.
Potential
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Municipal bonds allow investors to receive tax-free income, with a trade-off of lower yields than comparable corporate bonds. Investors who can buy taxable corporate bonds in tax-shielded accounts such as IRAs and 401k plans can take advantage of the higher returns of corporate bonds without the immediate tax consequences.
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