Corporate and municipal bonds play key roles in a portfolio, but be sure to know their differences, similarities, and risks before investing.
Corporate and municipal bonds are two types of bonds with unique characteristics and risks. If you are building a diverse bond core, these two types of bonds will likely surface in your research.
Corporate bonds are issued by companies, and municipal bonds are issued by government entities. Each bond has pros and cons and carries specific risks.
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Corporate Bonds
Corporate Bonds
Issued by companies to help fuel business expansion, refinance debt, and other capital-raising purposes.
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Municipal Bonds
Municipal Bonds
Issued by states, municipalities, local governments, and cities, largely to fund infrastructure projects.
Corporate bonds are bonds issued by companies. Unlike buying shares of a company’s stock and owning equity, investors who buy corporate bonds do not own equity in the company directly. Instead, corporate bondholders will earn interest on the bond and receive their principal at maturity.
Companies issue corporate bonds to:
The various types of corporate bonds include:
Investment grade corporate bonds are considered more likely to be paid on time compared to non-investment grade corporate bonds.
Non-investment grade corporate bonds, or high yield bonds, generally offer higher interest rates for the additional risk compared to investment grade.
Unlike Treasury bonds that are issued at the federal level by the US Treasury, municipal bonds, or “munis,” are issued by government entities including:
Municipal bonds are similar to Treasury bonds, where bondholders become creditors to the government. If you invest in, or buy, a municipal bond, you are essentially loaning money to the government issuer.
Government entities issue municipal bonds to pay for public infrastructure projects — like building roads, highways, or schools. Municipal bond investors will earn their principal investment back plus interest if they hold the bond through maturity and the issuer does not default, similar to other fixed income products.
Less commonly, munis can be issued on behalf of private entities such as non-profit colleges or hospitals.1
There are two common types of municipal bonds.
General obligation bonds are issued by states, cities, and counties but are not secured by any collateral. General obligation bonds are backed by the issuers’ ability to tax residents to pay bondholders.
Revenue bonds are not backed by taxing power. Instead, this type of municipal bond pays back investors through the revenue the issuer generates from the money raised by selling bonds. An example of this would be using toll revenue that a new highway generates to pay back bondholders.
Like other fixed income investments, both corporate and municipal bonds can pay investors in a number of ways, including:
Fixed rate bonds pay, as the name suggests, a fixed rate of interest. With fixed rate corporates, investors earn the same amount of interest, also known as a coupon payment, regardless of movements in interest rates.
Interest rates of floating rate, or variable rate, bonds reset periodically. These bonds are subject to movements in interest rates. This means when interest rates move up or down, the interest an investor earns also changes.
Investors may earn interest rates similar to a comparable Treasury bond, plus a little more.2
Zero coupon bonds make no interest payments until the bond matures. Instead, investors who hold these bonds to maturity, assuming the issuer can pay back its bondholders, will receive their principal and interest at the maturity date. For example, if an investor buys a zero coupon bond for $1,000 with a face value of $1,200, they will receive $1,200 at the date of maturity.
Although municipal bonds tend to have lower yields than corporate bonds, corporate bonds are subject to greater credit risk. A municipality can raise taxes to pay back its bondholders, but corporations cannot. If a company that issued corporate bonds goes bankrupt or cannot pay back bondholders, bondholders may have a claim on assets and cash flows of the company depending on the type of bond.
Here’s a summary of the differences between municipal and corporate bonds.
Figure 1: Compare Municipal and Corporate Bond Characteristics
| Characteristic | Corporate Bonds | Municipal Bonds |
|---|---|---|
| Issuers | Companies and corporations. | Cities, counties, states, and municipalities. Municipal borrowers sometimes issue bonds on behalf of private entities such as non-profit colleges or hospitals. These are known as conduit borrowers. |
| Taxes on Earned Interest | Interest income is usually taxable at an investor’s ordinary state and federal income tax rate. | Interest income is generally exempt from federal taxes and can be exempt from local and state taxes. |
| Risks | Usually riskier than municipal bonds, as companies can go bankrupt. Investors may have a claim to company’s cash flow or assets if the bond is a secured bond, but may not if the bond is unsecured. Companies usually pledge collateral with secured bonds, such as equipment, property, or inventory. | Usually less risky than corporate bonds, since municipal bonds are backed by issuer’s ability to raise taxes to pay back bondholders. |
| Liquidity | May have higher liquidity than municipal bonds. | May have lower liquidity than corporate bonds. |
| Yields | Generally offer higher yields than municipal bonds. | Generally offers lower yields than corporate bonds. |
Consider the pros and cons of both corporate versus municipal bonds.
Corporate bonds tend to offer higher yields than Treasury or municipal bonds, making them an attractive option for investors looking to earn income. Corporate bonds also have a low correlation to equities and can help diversify portfolios. Corporate bonds also provide regular income for investors who want to invest with a company, but don’t necessarily want to purchase stock. They also tend to be much more liquid than municipal bonds.
Despite higher yields, corporate bonds carry a higher risk of default, or credit risk. Additionally, corporate bonds like other bonds are subject to interest rate risks. Companies may not be able to pay back bondholders if they go bankrupt, or if they are unable to generate enough cash to pay back bondholders. High yield bonds, also known as junk bonds, carry a high risk of default but also have higher yields.
Municipal bonds are generally more tax efficient than corporate bonds since their interest usually isn’t subject to federal taxes, and is sometimes exempt from state and local taxes. While yields tend to be lower, default risk is also usually much lower than for corporate bonds.
While defaults are less common for municipal bonds, issuers of municipal bonds can still default. Municipal bonds are also less liquid than corporate and many other types of bonds, which can make it more difficult for an investor to buy and sell them. They also usually don’t offer as attractive yields compared to corporate bonds. Like other bonds, municipal bonds are also subject to interest rate risk.
A bond ladder is a strategy where an investor purchases a variety of bonds with different maturity dates. This can help investors mitigate interest rate risk. Is a bond ladder right for you?
