In our last post, we explored the differences between muni bonds and stocks, as well as FDIC-insured investments like CDs and savings accounts. Now it’s time to see how munis compare to other individual bond investments, such as Treasury bonds and corporate bonds, and FDIC-insured fixed-income products, such as Credit Deposits.
Munis vs. Treasury Bonds
Treasury bonds, or T-bonds, are bonds issued by the U.S. Department of the Treasury. When you buy T-bonds, you’re essentially loaning money to the federal government so that it can do things such as finance general operations or pay down the national debt.
Treasury bonds are issued with a minimum face value of $1,000. Like most municipal bonds, they make interest payments twice a year, but there are some key differences between the two. Let’s review.
- Risk: Though muni bonds boast a relatively low default rate, U.S. treasury debt is considered to be virtually risk-free. Some like to say that the U.S. has never defaulted on its debt, but those paying attention to detail will note that it did fail to make a scheduled payment to bondholders back in 1979. But historically speaking, defaults have been a relatively minimal concern for T-bond investors.
- Returns: Since 1900, T-bond interest rates have ranged from under 2% to over 15%, with an average of 4.9%. However, in early 2015 they were hovering closer to the 2%-mark. By comparison, Munis have have yielded 25-30% more than T-bonds on a tax-adjusted basis.
- Tax status: The interest on T-bonds is taxable at the federal level, but exempt from state and local taxes. Muni bonds, by contrast, are exempt from federal taxes and, in some cases, state and local taxes as well.
- Market size & liquidity: As of 2012, municipal bonds made up about 10% of the U.S. bond market, whereas treasury bonds encompassed close to 30%. Treasury bonds are also more liquid than munis or corporate bonds, meaning they’re easier to buy and sell. In fact, they’re considered among the most liquid assets available to investors. You can buy them online via treasurydirect.gov.
Munis vs. Corporate Bonds
Corporate bonds are structured in the same fashion as municipal and Treasury bonds: In exchange for lending the issuer, a company, a certain amount of money for a fixed period of time, you’ll get interest payments throughout the term of the bond, with your principal repaid in full once the bond comes due.
But in terms of risk and returns, corporates and munis are fairly different. Here’s an overview:
- Risk: Corporate bonds are 50 to 100 times more likely to default than comparably rated municipal bonds bonds. S&P reported only 47 muni bond defaults between 1986 and 2011, and Moody’s reported just 71 defaults between 1970 and 2011. And since 1970, there has never been a default on a bond rated AAA.
- Returns: The average yield on municipal bonds over the past 10 years has been just over 4%, whereas corporate bonds have averaged between 5 and 7%.
- Tax status: The interest earned on most muni bonds is exempt from federal taxes and, in some cases, state taxes as well. The interest earned from corporate bonds is subject to taxation at both the federal and state level. This means when you are calculating your expected returns from your investment, be sure to compare apples-to-apples by taking the Tax Equivalent Yield (TEY) of any municipal bond rates into account. As an example, the chart above shows the TEY of municipal bonds for an investor in the 28% federal income tax bracket.
- Market size & liquidity: As of 2014, the muni bond market topped out at approximately $3.6 trillion. The corporate bond market is much larger, with more than $11 trillion issues outstanding. Furthermore, corporate bonds are actively traded on the New York Stock Exchange, which makes them more liquid than munis. Muni bonds are currently bought and sold in what’s called an over-the-counter market, rather than an exchange.
- Disclosure: Corporate issuers are required to publicly disclose information that could impact their bonds, and bond prices must be disclosed as part of the trading process. Municipal bonds, however, don’t currently have the same disclosure requirements on both the part of issuers and brokers. But rest assured, Neighborly is working to change this. We imagine a future of full and complete transparency where you, the bond buyer, have open access to information and disclosures that will help you better understand your investment decision.
Muni Bonds vs. CDs and Savings Accounts
The third class of individual fixed income product for you to consider is a Credit Deposit (CD), sometimes called a Term Deposit. These products also offer fixed-returns over an agreed investment time period, but unlike Treasuries, Corporate bonds and Municipal bonds, they are federally insured, and are priced accordingly. Let’s dig into the details.
- Risk: CDs, savings accounts and money market accounts are all federally insured up to $250,000 per depositor. (If you open a joint account with a partner, you’re covered up to $500,000.) Within this limit, you’re guaranteed not to lose a penny regardless of how the market performs. While some municipal bonds are insured, some may be insured less than dollar for dollar and many have no insurance at all. Though loss of principal can’t be ruled out in the event of a default, munis have a very low default rate overall. Although municipal bonds are considered to be a relatively safe investment, if you’re looking for absolute peace of mind, it technically doesn’t get any better than an account that’s insured by the FDIC. Returns: FDIC-insured products offer lower interest rates than Munis, Corporates and even Treasuries, averaging historically very low interest rates, averaging around 0.44%.
- Tax status: Interest earned from CDs, savings, and money market accounts is taxed as ordinary income. Depending on your tax situation, the federal and state tax exemptions offered by municipal bonds may make them a more suitable investment.
- Withdrawals: With CDs, you’ll pay a penalty for early withdrawal — typically three months' worth of interest for a one-year CD or six months' worth of interest for a CD with a longer term. There are no penalties for selling muni bonds before they mature, although if you make a profit by selling at a higher face value, you’ll have to pay capital gains taxes. Losses may be offset on tax returns depending on how long you’ve held the bonds.
- Liquidity: Despite the early cash-out penalties on CDs, they are still considered to be more liquid than municipal bonds because you can close a CD at any time and get your principal back, subject to withdrawal limits and penalties. With municipal bonds, your principal is tied up for the term of the bond, and while you can sell at any time, doing so could result in a loss if the price of the bond has gone down in the market. Since munis are an OTC product, it may take some time to find a buyer – even if you’re willing to take a loss. On the flip side, you could also make a profit by selling a muni early.
- Minimum investment levels: For a savings account, the minimum can be as low as $100 depending on the institution. CDs and money markets typically require a $1,000 minimum investment, though products offering the highest rates may have higher thresholds. Muni bonds, by convention, have a $5,000 minimum, although Neighborly is working to lower this minimum. On three of the investment opportunities we offered in 2017, Cambridge, Burlington and Lawrence, the minimum investment was $1,000.
Evaluating Your Choices
Compared to other bond investments, munis offer a moderate amount of both risk and reward. While they aren't as secure as treasury bonds, they're less volatile than corporate bonds and in many cases offer tax advantages that neither treasuries nor corporates can match. And of course, no bond investment is as secure as an FDIC-guaranteed product such as a CD, but the safety of those products also comes with a corresponding discount in the yield you’ll earn, and there’s no tax advantage to be had.
So you think you’re ready to start considering individual bond investments? In our upcoming sections, we'll review some specific aspects of muni bond investing you'll want to consider, such as finances, taxes, credit ratings, and those rare-but-possible defaults.
In the meantime, you can head over to neighborly.com/explore to see what an individual municipal bond investment opportunity looks like.
This article was updated on November 3, 2017.
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