What Has a Higher Yield, Corporate Bonds or Municipal Bonds?
Today's financial markets can be complex to navigate. For a new investor or someone looking to diversify his investments, trying to decide what to invest in can be challenging. Investors have traditionally viewed bonds as relatively safe investments compared to stocks, which are more volatile. If you decide to invest in bonds, you should know whether corporate or municipal bonds are best suited to your needs and which can yield the best return.
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Corporate Bonds
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Corporate bonds are debt instruments issued by companies in exchange for capital to finance their operations. In exchange for purchasing the bonds, investors receive interest on their investment, payable at a specific date in the future, when the bond matures. The riskier a bond is, the higher the yield necessary to attract investors. Since corporate bonds have an inherent risk of default because companies may become unprofitable or even go out of business, the interest rate they offer is often higher than that of municipal bonds. Corporate bonds can be purchased through any major stock exchange.
Municipal Bonds
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Municipal bonds are issued by states and local governments to support infrastructure and public works like road construction, bridges and hospitals. Traditionally, municipal bonds have been seen as safer investments than corporate bonds, though in times of economic uncertainty like recession, investors view the probability local governments defaulting on its bonds as higher. Municipal bonds generally are issued for $5,000 and can only be purchased in the over-the-counter market. The yield on municipal bonds is typically lower than that of corporate bonds.
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Interest
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Interest earned on municipal bonds is always exempt from federal taxation, and in some cases state and city taxes as well. So, while municipal bonds on average offer a lower yield than corporate bonds, the difference between the two can be minimal once the amount of tax that has to be paid on interest earned from a corporate bond is taken into account. Furthermore, depending on the investor's tax bracket, which determines the amount of tax paid on interest, a municipal bond's post-tax yield can be greater than that of a corporate bond.
Tax Bracket
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The higher an investor's income tax bracket, the higher the TEY, or taxable equivalent yield, has to be on a corporate bond in order to equal that of a lower-yielding municipal bond. Municipal bonds typically provide the most financial benefit to those who are in a higher income tax bracket, since a municipal bond often yields a higher return after taxes. For investors in a lower income tax bracket, municipal bonds yields rarely match the higher returns from corporate bonds of similar risk.
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References
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