Bond investors have a choice of government, municipal or corporate bonds. Government-issued bonds are very safe, but offer low interest yields. 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.
Corporate bonds are debt securities issued by corporations as a way to borrow money. The yield of a specific corporate bond is dependent on the issuing company's credit rating. Corporate bonds can be rated as investment grade or high-yield, non-investment grade. At the time of publication, the FINRA Bloomberg Investment Grade Bond Index had a yield of 4.65 percent and the high yield version of the index was yielding 7.88 percent. All interest earned from corporate bonds is taxable by federal and state income taxes.
Municipal bonds are debt securities issued by state and local government entities. 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. Municipal bonds come in a range of credit quality, with credit ratings like corporate bonds. Lower rated bonds will pay a higher yield. According to the Municipal Market Advisors composite yield curve, at the time of publication, 10-year municipal bonds were paying 3 percent on average and yields for 20-year or longer maturing bonds averaged 4.5 percent.
Taxable Equivalent Yield
To compare the taxable yield of a corporate bond to the tax-free yield of a municipal bond, compute the taxable equivalent yield of the municipal bond. The equivalent yield is calculated by dividing the municipal bond yield by one minus the tax payers tax bracket. For example, with a tax bracket of 25 percent municipal yield of 3.5 percent. the 3.5 percent is dividend by 1 minus 0.25 resulting in 3.5 divided by 0.75, giving a taxable equivalent yield of 4.67 percent. The corporate bond yield must be higher than 4.67 percent to provide a higher after tax return to the investor.
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 is of longer maturities, 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 grade, high yield bond issuers.