If you are interested in investing in the fixed income market to lessen your financial risks, bonds may be the way to go. But it would be best for you to learn about the existing bonds categories before you spend your money.
Generally, three main bond kinds are available. As a bond investor, you have a choice of government, municipal or corporate bonds. Government-issued bonds tend to be pretty safe because they are usually backed by the full faith of the U.S. government. However, they offer low interest yields. So, if you want to minimize risk while getting decent returns, you may want to consider corporate or municipal bonds.
The competition in yield between corporate and municipal bonds is in the after-tax yield. Choosing one type of bond or the other is often dependent on the income tax bracket of the investor.
Read More: Definition of Stocks & Bonds
Corporate vs. Municipal Bonds
Below are some of the things you should know about corporate and municipal bonds.
Both public and private corporations tend to issue debt securities in the form of corporate bonds to raise capital. The yield of a specific corporate bond is dependent on the issuing company's credit rating.
Investment-grade bonds usually have higher ratings and lower credit risks. On the other hand, high-yield bonds usually have poorer credit ratings and higher credit risks. For that reason, they offer higher yields compared to corporate bonds in the former category.
At the time of publication, Moody's Seasoned Aaa Corporate Bond Yield (investment grade) had a yield of 2.73 percent, and Moody's Seasoned Baa Corporate Bond Yield was 3.40 percent. The latter is just one grade above a junk bond rating.
It is also worth noting that all the interest you earn from corporate bonds is subject to federal and state income taxes.
Municipal bonds are debt securities issued by state, city and local government entities.
Some are secured by assets, while others are secured by the full faith and backing of the local government issuer. Also, some municipal bonds are backed by government revenues, such as tool fees.
A major feature of municipal bonds is the interest paid to investors is exempt from income taxes. Municipal bond interest is exempt from federal taxes and interest from bonds from the investor's home state is also exempt from state income taxes.
Also, municipal bonds come in a range of credit quality, with credit ratings like corporate bonds. And similarly, lower rated bonds will pay a higher yield than those with higher credit ratings.
One FMS Bonds research shows that 10-year AAA-rated municipal bonds were paying 1.15 percent on average and yields for 20-year or longer maturing bonds averaged 1.5 to 1.7 percent.
Read More: Why Bonds Are Safer Than Stock
Taxable Equivalent Yield
The tax equivalent yield refers to the pre-tax return that a taxable bond would need to be equal to the yield of a tax-exempt municipal bond. So, to compare the taxable yield of a corporate bond to the tax-free yield of a municipal bond, you should compute the taxable equivalent yield of the municipal bond.
The formula is: Tax free bond yield/ (1-tax rate)
For example, if you belong to a tax bracket of 25 percent and the municipal yield is 3.5 percent, the 3.5 percent is divided by one minus 0.25, resulting in 3.5 divided by 0.75, This is giving a taxable equivalent yield of 4.67 percent. Therefore, the corporate bond yield must be higher than 4.67 percent to provide a higher after tax return to the investor.
Final Thoughts on Bonds
In addition to comparing the after tax yields of corporate and municipal bonds, an investor should be aware of other considerations. Corporate bonds tend to have shorter maturities, typically 10 years or less. A large portion of available municipal bonds have longer maturities of 20 to 30 years.
Insured municipal bonds with AAA credit ratings are readily available for investors looking for safety. The corporate bond market has only a handful of AAA-rated issuers and a large number of non-investment grades, high yield bond issuers. So, that’s also something to think about when considering the available bond kinds.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.