Why Own Corporate Bonds vs. Municipal Bonds

Higher potential after-tax returns

Corporate Bonds vs. Municipal Bonds

Many investors in high tax brackets favor muni bonds because they believe they can achieve higher after-tax returns. When Bondsavvy recommends corporate bonds, we are focused on maximizing each investment's total return, which includes a bond's capital appreciation and interest income. Given the more favorable tax treatment of capital gains vs. interest income, our total return strategy can achieve higher after-tax returns than munis.

We believe it is easier to identify capital appreciation opportunities in corporate bonds vs. muni bonds given the superior and more frequent financial disclosures required of corporate bond issuers. Corporate bond issuers must report financial results four times per year and report material events through 8-K filings with the US Securities and Exchange Commission (SEC). Municipal bond issuers typically provide annual filings, so it's difficult to assess a municipal bond issuer's health over the course of a year.

For example, on December 10, 2020, we did a search for the financial reports of the New Jersey Turnpike Authority, a large issuer of revenue bonds in the home state of Bondsavvy founder Steve Shaw. On this date, the most recent historical financials we could find were for the year ending December 31, 2019. While some budgeted 2020 numbers were provided, we have gone nearly an entire year from the end of 2019 without newly reported financial statements. This is par for the course for municipal bond issuers.

We identify bonds that can achieve strong total returns by determining if a potential corporate bond investment is undervalued relative to comparable corporate bonds. We calculate leverage ratios and other key metrics and compare these to a corporate bond's price, yield to maturity, and credit spread to determine whether the potential bond investment has upside potential and can achieve a strong total return.

BondSavvy Subscriber Benefit

Capital appreciation represents a substantial portion of the total return for many of our investments, which helps generate higher total returns than muni bonds. See Our Performance

Easier to buy and sell

Corporate vs. Municipal Bonds

Individual corporate bonds trade in a robust marketplace where typically 6 to 10 dealers are posting live bid-offer quotes for each bond CUSIP, a nine-digit bond identifier. It is a technology-enabled marketplace with reasonable bid-offer spreads as shown in the below table, which shows quotes available on Fidelity.com for the Alphabet 1.998% 8/15/26 bond (CUSIP 02079KAC1), which Bondsavvy previously recommended (click here to view this recommendation during the sample edition of The Bondcast). For this corporate bond, 10 dealers were providing live bid-side quotes while nine were providing live offer-side quotes. The bid-offer spread is narrow, as it is 0.20 points, on a dollar-price basis (94.550 less 94.350), and 3 basis points (0.03 percentage points), on a yield-to-maturity basis, calculated by taking 2.857% less 2.826%.

These narrow bid-ask spreads are driven by the high level of competition among the quoting dealers, all of which are vying for your corporate bond trades.

Corporate bonds are in stark contrast to muni bonds, as munis do not have a live bid-offer market with multiple dealers quoting. Instead there is one dealer quoting only on the offer side, which makes it hard to know the price at which you can sell the bonds.

This superior liquidity makes it easier to buy and sell individual corporate bonds vs. municipal bonds.

Greater transparency

Individual Corporate Bonds vs. Municipal Bonds

Investors are always learning more about corporate bond issuers through quarterly earnings releases, investor presentations, executive interviews, and other SEC filings. This enables investors to quickly assess the financial health of a company and invest accordingly. Municipal bond issuers, on the other hand, have far less stringent reporting requirements, often reporting their financials just once per year.

In addition, the pricing of corporate bonds is more transparent than that of municipal bonds, as corporate bonds enjoy a robust, two-sided market with between six to nine dealers providing live-and-executable bid-offer quotes. Municipal bonds do not have multiple dealers providing live quotes, which can make assessing the value of a municipal bond more difficult. Further, since there are thousands of corporate bond CUSIPs compared to millions of municipal bond CUSIPs, there is a greater level of trading activity in each corporate bond vs. municipal bonds. Therefore, when investors search for a specific bond, they can often see 25 to 50 trades per day taking place in the same bond, which enables investors to assess the fairness of the prices being quoted. Since there are so many more municipal bonds, many munis can go months without trading, which often makes price discovery an uphill battle for municipal bond investors.

Greater variety of risk/return investments

Corporate Bonds vs. Muni Bonds

Given the wide range of corporate bond credit profiles, we like to say "there's a corporate bond for everyone." For example, a May 28, 2019 Fidelity.com corporate bond search returned 7,680 investment-grade bonds (bonds rated at least Baa3 by Moody's and BBB- by S&P) and 1,357 high-yield bonds, which are rated Ba1/BB+ or lower. With this variety of credit profiles, investors can create corporate bond portfolios suited to their risk tolerance and investment returns objectives.

On the other hand, municipal bonds generally have only the highest credit ratings and, as a result, less opportunity for higher investment returns. In a July 3, 2019 search for municipal bonds available on Fidelity.com, of the 19,000 bond search results, only 104 had credit ratings lower than an A rating by S&P, and all of those 104 bonds were rated BBB+. In addition, while states such as California and Florida have a seemingly unlimited supply of municipal bonds, other states such as Delaware, Montana, Mississippi, and New Hampshire have relatively few offerings. As a result of these factors, investment choice can be severely constrained for those investors seeking exemption from state and local taxes and the opportunity for high return investments.

Another perspective

This article reviews our rationale for owning corporate bonds vs. municipal bonds. As we discuss, higher income and capital appreciation opportunities are among the reasons investors may elect to own corporate bonds vs. municipal bonds. Investors seeking income and capital appreciation opportunities may also wish to explore owning dividend stocks and may be interested in the following dividend stock websites:

Dividend Aristocrats
Dividend Kings
Monthly Dividend Stocks