Key Takeaways
- Municipal and corporate bonds may both be key components to a diversified portfolio.
- Municipal bonds offer tax advantages and lower risk, making them useful for high-income investors or those with taxable accounts.
- Corporate bonds, on the other hand, usually offer higher yields but carry greater credit risk and taxable interest income.
- Neither is consistently superior to the other.
- The right choice for any client comes down to their tax bracket, account type, income needs, and risk tolerance.
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One of the most common concerns clients of financial advisors have is how to balance tax efficiency and yield. There is no one-size-fits-all approach; practical decision-making for retirement-focused clients involves considering taxes, income needs, account type, risk tolerance, and other factors.
Having a conversation with clients about the trade-offs between tax efficiency and yield can help them to make an informed decision about municipal vs. corporate bonds in their portfolios.
Crucially, neither munis nor corporate bonds are necessarily superior to the other for most clients. The variables above impact which of these two—or how a balance of both—may create an appropriate fit for those looking ahead to retirement.
Key Differences
Municipal bonds and corporate bonds differ in a host of ways, from issuer to risk level to interest rates. The core trade-off between these two types of bonds tends to be tax efficiency vs. income potential, with munis getting the advantage in the former and corporates in the latter.
Municipal bonds are issued primarily by state and local governments and may appeal because they are exempt from certain types of taxes. That gives investors the opportunity to build tax-advantaged income, which may be particularly interesting to clients in high tax brackets or others seeking to limit their tax burden. Munis generally have lower yields as a result.
Corporate bonds—those issued by companies—tend to offer higher yields, which is appealing to investors seeking to maximize their interest income. The interest on corporate bonds, though, is taxable and, because they are tied to specific companies that could potentially fail, somewhat more risky than munis.
When Municipal Bonds Work Best
The most attractive aspect of municipal bonds is their exemption from federal taxes and, in some cases, local taxes, depending on where the investor lives. Highly rated munis also have very low default rates.
“Muni bonds can be very attractive investments,” said Jeffrey Golden, CFP, of Circle Advisers Inc., in New York. This is especially true for high-income investors who also live in high-tax states, he said.
The tax advantages of municipal bonds make them useful for taxable brokerage accounts, too. Because interest income is exempt from at least some taxes, the after-tax yield becomes higher in some cases.
Highly rated munis (those rated investment grade or better) have a historical default rate of “less than 1%,” according to Golden, making them very low-risk investments for clients looking to prioritize after-tax income stability.
When Corporate Bonds Work Best
Corporate bonds may work best for clients in lower tax brackets who are less concerned about seeking tax efficiency and more focused on higher yield potential. Investment-grade bonds carry some moderate credit risk, but it’s important to emphasize that, in most cases, their default risk remains quite low.
Because of corporate bonds’ status, generating ordinary income, they are tax-inefficient in standard taxable accounts. However, tax-advantaged IRAs or 401(k)s can help prevent tax drag, allowing investors to keep the full coupon and reinvest it.
How to Think About Risk and Yield
One of the most important things for clients when it comes to risk is to know the importance of talking about it at all, after years of chasing maximum returns.
“A lot of retirees [have] spent their careers ignoring fixed income and then suddenly it matters a great deal,” said Jeffrey Judge, CFP, AEP, ChFC, CLU, of Chesapeake Financial Planners in Forest Hill, MD. Judge summed up the key distinction between munis and corporates like this: “Munis trade yield for tax efficiency; corporates trade safety for income.”
Instead of thinking one is better than the other, keep in mind that “they’re solving different problems,” Judge said. Corporate bonds have to pay more because investors expect a premium when they buy bonds with additional risk compared to munis.
Important
Munis are generally less risky than corporates, but because of credit quality differences across issuers it’s important not to over-generalize about the safety of all municipal or corporate bonds.
Comparing tax yields is crucial, but yield comparisons only make sense if viewed on an after-tax basis.
“I had a client who was holding a significant muni ladder inside his IRA. It was costing him real money every year because the tax advantage he was paying for didn’t exist in that account,” Judge said. As such, account type should perhaps be the first variable to consider.
Risk variation is key as well. While it’s true that risk varies more widely in corporate bonds than in munis, credit risk can also show up in retail investor portfolios due to concentration. By investing heavily in municipal bonds from one state, for example, or in corporates from a single sector, investors may unwittingly put themselves at greater risk if something specific to that state or sector goes wrong.
Building a Balanced Approach
A balanced approach starts with assessing the purpose behind the decision to buy a muni or corporate bond. For Judge, that means deciding “what the money is for and where it lives.”
For taxable accounts with higher marginal rates, a muni-focused bond approach may be best. Tax-deferred accounts that prioritize yield means that “corporates earn their spot,” Judge said.
One approach could be to ladder maturities across both of these types of bonds to give added flexibility; that way, the investor isn’t “locked in” if rates move, Judge noted.
Your clients’ income needs, as well as broader market conditions, may be the crucial factor after the variables above in setting allocation between munis and corporate bonds in the same portfolio.
The Bottom Line
Municipal bonds tend to offer tax advantages and lower risk, which makes them particularly useful for high-income investors or those with taxable accounts. Corporate bonds, on the other hand, usually offer higher yields but carry greater credit risk and taxable interest income.
Neither of these options is consistently better than the other. The right choice for any client comes down to their tax bracket, account type, income needs, and risk tolerance. A balanced strategy that incorporates both while diversifying across parameters like maturity and issuer may be an ideal approach in many cases.