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Fixed Income After-Tax Returns: How Corporate Bonds Beat Munis

Many people invest in municipal bonds because they believe munis drive higher after-tax returns than corporate bonds.  This blog post shows this is not always the case.

The Punchline
If investors buy individual corporate bonds, rather than bond funds and ETFs, they can find bonds that can appreciate in value and drive strong total returns. In many cases, the return from capital appreciation can exceed the return from coupon payments. When this happens, after-tax returns can surpass those of muni bonds. In addition, the greater transparency and liquidity available in the corporate bond market compared to muni bonds can make corporate bonds a compelling alternative to munis.

An 8.94% After-Tax Return for a Corporate Bond
Munis get all the accolades when it comes to after-tax returns.  What investors have not been realizing, however, is how corporate bonds can outperform munis on an after-tax basis.   

Below is an example of an investment I made in Microsoft 4.000% '55 bonds that achieved an 8.94% after-tax return.  

On February 12, 2016, I bought 10 Microsoft bonds at 92.17.  With commission, I invested $9,237.30.  From the investment date through September 30, 2017, I received $647.77 in interest.  On September 30, the price of the bond was 103.90, which resulted in $1,152.80 of capital appreciation.  Since I bought the bond at a discount, its yield at the time was 4.33%, or 2.60% after tax, assuming a 40% combined federal and state income tax rate.  The annualized return from capital appreciation was 7.46%, or 6.34% after tax, assuming a 15% capital gains tax rate.  Combined, the after-tax rate of return was 8.94%.      

Corporate Bond Returns Microsoft

Other Benefits of Corporate Bonds vs. Munis
In addition to potentially higher after-tax returns, corporate bonds have several other advantages relative to muni bonds, including:

1) A robust, "two-sided" market with live bid and offer quotes
2) More stringent and recurring financial reporting requirements
3) Higher trading activity in each bond so you can better assess if you are investing or selling at a fair price

Corporate bonds trade in a highly competitive marketplace with typically five to seven dealers providing bid-offer quotes for the same bond.  In munis, generally one dealer quotes a bond and it is only on the offer side of the market.  Since individual munis often have limited trading activity, it can be difficult to assess the price at which you could sell that same bond and how your investment price compares to recently reported trades depending on how frequently a particular muni bond trades.

When I look to uncover bonds with compelling values to others, I compare current financial statements of multiple issuing companies.  Doing this for a company that files quarterly with the SEC is pretty straightforward.  In comparison, muni bond issuers generally have annual filing requirements, which makes it difficult to have actionable information you can use.  For example, the New Jersey Turnpike Authority filed its 2016 annual report on May 23, 2017 so it will be until next May until we see another comprehensive financial report from this issuer.

Food for thought the next time you are deciding whether to invest in a muni or a corporate bond.

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