Municipal vs. Corporate Bonds: How to Choose

How do you choose between corporate and municipal bonds? Both have characteristics that can be useful in your portfolio, depending on your goals and circumstances, but they're not right for every situation.

First, start with the type of account you're using:

• Interest income from municipal bonds is generally exempt from federal and potentially state income taxes, so munis can make more sense than corporate bonds in taxable accounts, like a brokerage account, but it will depend on a few factors that we'll discuss below.
• For tax-deferred accounts, such as an individual retirement account (IRA) or 401(k), corporate bonds generally make more sense because they usually pay higher yields in exchange for the lack of tax benefits that munis usually offer.

Beyond that, you should be aware of factors such as yields, maturity, and credit quality, as they can differ between the two types of bonds and influence which is more attractive. Here's what you should consider when deciding between investment-grade municipal and corporate bonds.

As noted above, if it's a tax-deferred account, such as an IRA or 401(k), then corporate bonds will likely make more sense than munis.

A key benefit of municipal bonds is that their coupon payments are generally exempt from federal and potentially state income taxes, and they aren't subject to the 3.8% tax on high earners' investment income.  

For tax-advantaged accounts, however, that benefit goes away, because earnings aren't taxed until the time of distribution (usually at a later date). As a result of the tax benefits, munis tend to pay a lower rate of interest relative to corporate bonds of similar maturity and credit quality, so holding municipal bonds in a tax-deferred account likely means you're missing out on higher yields that corporate bonds can provide.

One caveat is taxable municipal bonds. Their interest income is subject to federal and state taxes, just like corporate bonds. Corporate bonds historically have yielded more than taxable municipal bonds because they generally have lower credit ratings, on average, but there have been times where taxable munis yielded more than corporate bonds. In instances such as these, taxable munis should be considered along with corporate bonds for tax-deferred accounts.

If you're investing in a taxable account, like a brokerage account, the decision between corporates and munis gets more nuanced and depends on a variety of factors. The primary factor will be your tax rate. At higher tax rates, munis generally yield more than corporate bonds of similar maturities.

For example, the seven-year component of the Bloomberg Municipal Bond Index yields 3.0%, compared with 5.4% for the Bloomberg U.S. Intermediate Corporate Bond Index.¹ Both indices have similar durations, a measure of interest-rate sensitivity, and therefore offer a reasonable comparison, in our view.

The corporate bond index offers a higher yield before taxes are taken into consideration—but once taxes come into play, that yield advantage begins to decline. In order for the municipal bond index to break even with the after-tax yield of the corporate bond index, a 45% total cumulative tax rate is needed. We're referring to this as the "break-even" rate. The current break-even tax rate is off its recent highs, but still at the high end of its 10-year range. Keep in mind that this break-even tax rate includes multiple types of taxes—such as federal, state, and potentially the 3.8% net investment income tax (NIIT). For example, you might be in the 37% federal tax bracket, live in a state with a 10.75% top marginal income tax rate, and be subject to the 3.8% NIIT, which would put your tax rate above 50%.

If your total tax rate is below 45%, intermediate-term corporate bonds will likely make more sense than intermediate-term municipal bonds after taxes. However, if your tax rate is above that ~45% break-even tax rate, municipal bonds will likely yield more after taxes. Don't always assume that this is static because the break-even rate has fluctuated over time, as illustrated in the chart below. Since 2010, this break-even tax rate has averaged 32%.

If you're looking for very highly rated investments, like "triple A" or "double A" rated bonds, corporates likely don't make as much sense. Munis may make sense depending on your tax bracket and what maturity you're considering. Most investment-grade munis carry ratings in the upper tiers of the investment-grade spectrum, meaning AA ratings or above by Standard & Poor's or Aa and above by Moody's Investors Service.²

Although the corporate bond market is more than four times larger than the municipal bond market, there are actually more AAA and AA rated munis than there are AAA and AA rated corporate bonds. In fact, there are only 13 unique issuers³ of AAA rated bonds in the Bloomberg U.S. Corporate Bond Index, with two issuers accounting for the vast majority of the AAA rated corporate bonds outstanding.

This matters because diversification with AAA rated corporate bonds is harder to achieve given the small number of AAA rated issuers in the corporate market relative to the muni market. Likewise, municipal bond investors looking for lower-rated investment-grade bonds and the higher yields they offer don't have too many options.

While there are fewer A and BBB rated municipal bonds outstanding relative to the corporate bond market, they historically have defaulted at a lower rate than corporate bonds with similar ratings.

This is generally due to municipalities having a natural monopoly on the residents they serve. For example, residents are generally limited to only one water utility district, which means that district doesn't have to compete for customers like corporations do. Municipal issuers also generally exhibit less business risk than corporations do.

If you're looking for short-term bonds with very high ratings, consider certificates of deposit (CDs), Treasuries, or agency bonds (that is, securities issued by a government-sponsored enterprise or a federal department other than the U.S. Treasury). There aren't many short-term AA or AAA rated corporate bonds available, and the average yields for the ones that are available are barely higher than Treasury yields.

To illustrate, a two-year AAA muni yields 2.9%, compared to 4.8% for a two-year Treasury note. For investors in very high tax brackets, munis may still make more sense than Treasuries, but that break-even tax rate is still relatively high.

The story changes when considering bonds that are lower-rated and have longer maturities. Either munis or corporate bonds could make sense when compared to Treasuries, but which to choose will depend on your tax bracket.

The tables below illustrate the average yields-to-worst of A and BBB rated muni and corporate bonds, based on maturity and tax rates. The columns on the left labeled as "Municipal yield"  represent average municipal bond yields based on the given maturity, and those yields don't change based on the tax rates since they are not subject to federal taxes. The columns labeled "Corporate bond yield" are the average, before-tax corporate bond yield for the maturities listed, and the columns to the right represent the yields after taxes assuming different tax rates.

The yields highlighted in yellow are instances where the corporate bond yields are higher than the municipal yields when the given tax rate is taken into account. Consider the example highlighted in the red dashed line in the table below, in which the average 10-year A rated corporate bond yields more after taxes than the average 10-year A rated municipal bond for investors in all but the 35% and 37% tax brackets.

Notably, A rated munis, on average, offer higher after-tax yields for all maturities shown for investors in the 35%-and-above tax brackets. When comparing BBB rated munis and corporates, there are very few instances when corporates yield more than munis on an after-tax basis.

Do your homework before investing in municipal bonds and corporate bonds, but also figure out how each investment fits into your risk profile and how each may help you reach your goals. Corporate and municipal bonds come with risks that always need to be considered when deciding which types of bonds to invest in—like interest rate risk (the risk that prices fall if yields rise) and credit risk, like the aforementioned risk of default.

The type of investment account or your tax bracket are just two things to consider—you also need to consider the credit quality, the time to maturity, and how the taxable equivalent yields stack up.

Municipal bonds tend to make more sense in taxable accounts for investors in higher tax brackets, but it will depend on the maturity and credit quality.

In tax-advantaged accounts, investment-grade corporate bonds generally will offer higher yields, but keep in mind that their credit ratings are lower, on average, and they have historically defaulted more than investment-grade municipal bonds. Schwab clients considering municipal or corporate bonds can explore Schwab's Mutual Fund OneSource Select List or the ETF Select List. When searching for corporate bond funds in the select lists, first start in the "Taxable Bond" category, and then search for "Corporate Bond" under the Morningstar Category. When searching for municipal bonds, simply start in the "Municipal Bond" category.

A Schwab fixed income representative can also help you find the right solution to help you reach your goals.