The following is adapted from Keep It Simple, Make It Big.
Bonds are an important part of any investment portfolio. With greater stability and lower risk than stocks, they are essential for shorter-term investments and for stable ballast to a long-term portfolio.
Even if you know you should invest in bonds, though, you might not know which bonds to choose. Not all bonds are the same, and which ones you choose can have a big impact on your returns.
There are two major categories of non-federal bonds: corporate bonds and municipal bonds. The main difference between the two is that, with corporate bonds, you are giving money to a corporation, while with municipal bonds, you’re giving money to the government.
As a result of this key difference, the two types of bonds are taxed differently and tend to have different interest rates. Deciding which is the better choice for you will depend on your individual circumstances, particularly your tax bracket.
Corporate Bonds
Bonds, sometimes referred to as fixed-income investments, are debt instruments. With corporate bonds, you provide money to a corporation to use for a fixed time period. In exchange, the corporation agrees to pay a set interest rate. Once the period has expired, say five, ten, or twenty years, the corporation returns your money.
Returns from corporate bonds are taxed in two ways: the interest is treated as ordinary income; the gains are taxed as capital gains.
Consider this example:
Joe purchases a $1,000 ten-year bond issued by General Electric with an annual interest payment (called a coupon) of 6 percent. He purchases it five years after it was first issued, and though it has a face value of $1,000, he only pays $800 for it. (Joe likely gets his discount for one of two reasons. Either interest rates have risen since the bond was issued or GE’s credit profile has declined.)
Every year, Joe receives $60 in interest from GE. This is added to the first page of his tax return, and he pays ordinary income taxes on it.
He holds the bond to maturity, at which time GE sends him a check for $1,000, earning him a capital gain of $200. This will be taxed at the favorable capital gains rate—probably lower than income tax rates.
Municipal Bonds
With municipal bonds, you are providing money to a government. Bonds issued by states and municipal governments are free of federal tax. If they are issued in the state in which you live, they are generally free of state tax as well.
There are two types of tax-advantaged municipal bonds: general obligation bonds and revenue bonds.
General obligation bonds are backed by the general taxpayers and the full faith and credit of the issuing government and its ability to generate the general tax revenue to pay bondholder’s interest. They are approved by the voters. They may support such things as schools or other capital projects.
Revenue bonds are issued by a municipality to support some project that is expected to generate revenue, such as toll roads or airports. Bondholders are repaid by the revenue from the specific project. No revenue, no payment.
Many revenue bonds are exempt from federal taxation, but some are not. You need to check. For instance, the federal government will not allow a tax exemption for municipal bonds that are issued to replenish an underfunded pension or to fund essentially private projects even if nominally public owned, such as sports stadiums.
Since municipal bonds are tax free, they can pay a lower interest rate per level of perceived risk than a corporate bond.
How to Choose Between Corporate and Municipal Bonds
In general, the higher one’s tax rate, the more attractive municipal bonds become.
To decide if a municipal bond is appropriate for you, you should calculate the taxable equivalent yield of a corporate bond, which you do by dividing the municipal bond’s interest rate by one minus your marginal tax rate:
Municipal Bond Interest Rate ÷ (1 – Marginal Tax Rate) = Equivalent Yield of Corporate Bond
Consider Doreen’s choice. She has $100,000 she wants to use to purchase a lot in a lake community in five years when her children are old enough to be strong swimmers. She wants her money to work for her but does not want to take the risk that the stock market will be down when she needs the money.
For her, bonds with a five-year maturity are a good option. She is in the 22 percent federal tax bracket, and her state taxes her at 5 percent, for a total marginal tax rate of 27 percent. A corporate bond will pay her 7 percent interest. A municipal bond will pay her 5 percent.
In which should she invest?
In her case, the equation looks like this:
0.05 ÷ (1 – 0.27) = 0.0685 (or 6.85 percent)
Therefore, for her, a municipal bond paying 5 percent is equivalent to a corporate bond paying 6.85 percent.
The corporate bond is 7 percent, so for Doreen, it is a better deal, if it has an equivalent risk as the municipal bond.
Alternatively, if she was in the 37 percent federal tax bracket and 5 percent state, the equation would be:
0.05 ÷ (1 – 0.42) = 0.086 (or 8.6 percent)
In that case, she should jump on the municipal bond, since it has a higher equivalent yield than the corporate bond.
Which Type of Bond is Right for You?
It’s tempting to say that municipal bonds are better because they’re tax-free, or that corporate bonds are better because they have higher interest rates.
The truth is that there is no one right answer here. It depends on the bonds’ interest rates and your marginal tax rate.
Even if at one point corporate bonds were the right choice for you, municipal bonds might be better later, if you move tax brackets or if interest rates fluctuate. So this is a decision you should revisit periodically.
Bonds are a great investment option, but it’s worth doing a little calculating to be sure you are choosing the type of bond that will give you the best returns.
For more advice on bonds, you can find Keep It Simple, Make It Big on Amazon.
Michael Lynch is a CERTIFIED FINANCIAL PLANNERTM professional with nearly twenty years of experience working with American families to craft plans that fund their dreams, educate their children, and finance their retirement. Michael has contributed to the Wall Street Journal and Investor’s Business Daily, and hosted Smart Money Radio for a decade. He’s served as an adjunct faculty member at Fairfield University and currently teaches financial planning to employees of corporations like Madison Square Garden and Yale New Haven Health Systems. Michael is a five-time Financial Planner of the Year for MetLife and a 2019 inductee to the Barnum Financial Group Hall of Fame. You can enjoy his latest articles and videos at www.michaelwlynch.com.
Representatives do not provide tax and/or legal advice. Any discussion of taxes is for general informational purposes only, does not purport to be complete or cover every situation, and should not be construed as legal, tax or accounting advice. Clients should confer with their qualified legal, tax and accounting advisors as appropriate. Securities and investment advisory services offered through qualified registered representatives of MML Investors Services, LLC. Member SIPC. 6 Corporate Drive, Shelton, CT 06484, Tel: 203-513-6000. CRN202210-272627