What Are the Advantages & Disadvantages of Both Corporate & Municipal Bonds?
Bonds are types of debt instruments in which a creditor agrees to lend money for a number of years in exchange for interest payments. State, county and city governments throughout the United States issue municipal bonds. Corporations also issue bonds, with larger more stable companies tending to offer lower yields than smaller companies, which have a higher risk of defaulting on payments.
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Function
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Municipalities issue two main types of bonds: general obligation bonds and revenue bonds. General obligations bonds pay for basic services, have no collateral and rely on the financial strength of the issuing entity. Interest payments are made with income received from taxation. Revenue bonds are attached to projects such as toll roads, and bondholders receive payments tied to the project's income.
Corporate bonds are sold to raise funds for operating costs, expansions, product development and takeovers of other firms.
Time Frame
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Bonds are issued with terms ranging from a month to 30 years. Bonds pay interest monthly, quarterly, semi-annually or annually. Many people buy bonds indirectly through purchases of mutual funds that contain bonds. People who buy A-shares of bond mutual funds, pay up-front fees of 4 or 5 percent but can sell the shares at any time. C shares in bond funds cost nothing upfront but shareholders pay a 1 percent fee if the funds are held less than a year. B shares in bond funds charge no upfront fees but charge back-end fees if sold within seven years.
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Benefits
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Most municipal bonds are exempt from federal income tax. People who buy municipal bonds issued by municipalities within the state where they reside do not have to pay state income tax on the interest payments. People who live in states such as Florida that have no state income tax can buy municipal bonds from any state and enjoy tax-free income.
Corporate bonds generally offer higher yields than government bonds, though the income is taxable. Retirees often buy corporate bonds with retirement money and live off the income.
Considerations
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Many people who earn over $100,000 a year are subject to the federal alternative minimum tax. High earners should consult tax professionals before buying municipal bonds as tax-free instruments because the Internal Revenue Service may require them to pay AMT tax on some or all of their interest earnings.
Unlike municipalities, corporations struggling financially cannot raise funds through taxes. Businesses have higher bond default rates than governments, and during a bankruptcy bondholders often lose some or all of their investment.
Warning
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Both corporate and municipal bonds expose investors to a variety of risks. Long-term bonds tend to pay modest interest and inflation often outpaces bond income, which means bondholders have less spending power over time. Many bonds are callable, which means the issuing entity can pay the bondholders back at any time. This impacts people who rely on the steady income.
Neither the money invested in municipal bonds nor the funds in corporate bonds are principal protected by the Federal Deposit Insurance Corporation.
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