Not Every Bond is a Municipal Bond: How Investing in Your City Compares to Bond Funds, Corporates and Treasuries
In our last section, we compared the differences between muni bonds and stocks, as well as FDIC-insured investments like CDs, savings, and money market accounts. Now it’s time to see where munis fall within the parameters of bond investing. Corporate bonds, treasury bonds, and mutual bond funds are all attractive options in their own right, but let’s see how munis fare in comparison.
Munis vs. Corporate Bonds
Municipal bonds are generally considered to be less risky than corporate bonds. Muni bonds could be less liquid, but if you have a corporate bond and a muni bond with the same credit rating, statistically speaking, you’re least likely to lose money if you opt for the muni bond.
Corporate bonds and municipal bonds are structured in the same fashion: In exchange for lending the issuer (government for munis and companies for corporate bonds) 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. The primary difference between the two relates to:
- Default rates: Muni bonds are 50 to 100 times less likely to default than comparably rated corporate 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, or in this case, taxes-to-taxes.
- 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, by contrast, are typically bought and sold in what’s called an over-the-counter market, which means they’re not traded on 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.
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 pay down national debt or finance general operations.
Treasury bonds are issued with a minimum face value of $1,000 and a maturity of over 10 years. Like most municipal bonds, they make interest payments twice a year, but there are some key differences between the two with regard to:
- 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 generally speaking, defaults are not a point of concern with regard to T-bonds.
- 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. Historically speaking, muni bonds 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 far more liquid than munis. In fact, they’re considered among the most liquid assets available to investors.
Munis vs. Mutual Bond Funds
A mutual fund works by investing its investors’ money into a variety of investment vehicles, thus allowing them to diversify. Mutual bond funds — those that focus on bond investments, as opposed to stocks — allow participants to invest in multiple bond issues without having to worry about individual investment minimums. That’s because these funds are able to pool their participants’ resources to purchase bonds.
Since muni bonds generally come with a minimum investment requirement — something that Neighborly is working to change — many investors can easily get priced out of the bonds they’re interested in purchasing. Mutual bond funds come with minimum investment requirements too, but whereas an individual muni bond is likely to require a $5,000 minimum, you can most likely find a bond fund with a $1,000 minimum.
While some mutual bond funds focus on corporate issues, there are those whose strategies revolve around municipal bonds. And among those, there’s even a subcategory of mutual bond funds that invest primarily in muni bonds issued by specific states.
From a risk-related perspective, most would consider mutual bond funds to be less risky than individual bonds because of their diversified nature. Even if a particular investment loses value or even defaults, a well-managed mutual bond fund will have its assets spread widely enough to more easily absorb this type of loss. With an individual bond, a decline in market value will be more pronounced, and a default is bound to more greatly impact investors.
On the other hand, mutual bond fund returns can suffer when interest rates go up. When interest rates rise on a whole, individual bond prices tend to go down. But if you buy a bond with a decent interest rate and hold it till maturity, you won’t lose out on any money. Cash out a mutual fund investment at a time when interest rates are higher, and you may end up taking a hit.
Though mutual bond funds offer the advantage of diversified holdings and built-in portfolio management, they also tend to come with hefty fees. Those fees, in turn, can eat into your profit, whereas if you’re able to buy a muni bond directly, your profit is yours to keep. Also, for those who prefer a hands-on approach to investing, ceding control to mutual fund managers may not be so appealing. When you purchase individual muni bonds, you get a chance to evaluate their credit risk and decide whether they’re right for you. Just as importantly, you get an opportunity to invest in projects or communities that are important to you.
As far as performance goes, mutual bond funds that focus on munis may offer returns that are similar to those generated by individual issues, only with less perceived risk. Recently, the five-year average return for intermediate-term municipal bond funds has been reported as 4.42%, and some state-specific funds have averaged upward of 4% over the past 10 years. These numbers are comparable to the average return on individual munis, but holders of individual muni bonds can avoid the annual management fees associated with mutual funds.
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 though they’re comparable to certain mutual bond funds, they may cost less to purchase individually. In our upcoming sections, we’ll review some specific aspects of bond investing you’ll want to consider, such as muni bond finances, taxes, credit ratings, and those rare-but-possible defaults.