Muni Bonds vs. Taxable Bonds

Executive Summary

Municipal bonds offer a compelling advantage over taxable bonds for high-income individuals due to their tax-exempt status, particularly at the federal level and often at the state and local levels as well. This tax efficiency can significantly boost after-tax returns, making muni bonds especially attractive in high tax brackets where marginal rates can exceed 40%. In many cases, the tax-equivalent yield on municipal bonds surpasses that of similarly rated corporate bonds, without taking on additional credit risk. Furthermore, municipal issuers—such as state and local governments—have historically demonstrated strong creditworthiness and low default rates, offering a relatively conservative way to preserve capital while optimizing tax outcomes.

Why Muni Bonds Exist

Municipal bonds (or “munis”) exist as a way for state and local governments to raise money to fund public projects and services. These might include:

• Infrastructure: roads, bridges, water systems, airports

• Public services: schools, police/fire stations, hospitals

• Economic development: housing, transportation, utilities

They allow governments to borrow from investors rather than raise taxes immediately. In return, investors get tax-advantaged interest income—often exempt from federal, and sometimes state/local taxes.

Municipal Bonds vs. Taxable Bonds: Why Tax Efficiency Matters

For investors seeking steady income, bonds are a natural choice. But not all bonds are created equal when it comes to taxes. Understanding the difference between municipal bonds and taxable bonds, and how to compare them fairly, is essential for smart investing.

Municipal Bonds: A Tax-Advantaged Option

Municipal bonds ("munis") are issued by state and local governments. Their key advantage is that the interest income is typically exempt from federal income tax, and often from state and local taxes if you live in the issuing state.

Because of this tax benefit, municipal bonds often offer lower stated yields than comparable taxable bonds. However, once you factor in the taxes you'd otherwise pay, the after-tax return from munis can actually be more attractive — especially for investors in higher tax brackets.

Taxable Bonds: Higher Yields, But Higher Taxes

Taxable bonds (like U.S. Treasury bonds, corporate bonds, or high yield bonds) usually offer higher nominal yields. However, the interest they pay is subject to federal income taxes (and sometimes state taxes too). For investors in high tax brackets, the after-tax yield can be significantly lower than the headline yield.

Muni Bonds: Lower Default Rates

Municipal default 10-year cumulative default rates portray a picture of relative stability versus its corporate counterparts. According to Moody's 10-year cumulative default rates in the high yield municipals are 3.97% versus 32.53% in high yield corporates. The difference becomes even more stark when comparing investment-grade rates of 0.04% in investment-grade municipalities versus 1.85% in corporates. These solid fundamentals create an environment where high yield munis have the potential to outperform in the near term. While no investment is without risk, the risk/reward ratio for high yield munis may be favorable for investors seeking both income and potential for capital appreciation.

How to Compare: Calculating the Tax-Equivalent Yield (TEY)

To compare a municipal bond fairly with a taxable bond, you need to calculate its tax-equivalent yield.

The formula is:

Example:

• A municipal bond yields 3.0%.

• Your marginal federal tax rate is 37%.

Then:

This means a taxable bond would need to yield 4.76% just to match the municipal bond's after-tax return.

If your state taxes interest as well, you can adjust the formula to include both federal and state taxes for an even more accurate comparison.

Tax Equivalency Table

Example: A single individual living in New York City making $500,000 per year would need to find a government or corporate bond yielding 5.5% to be the equivalent of a municipal bond yielding just 3.0%.

If you’re curious about how your return is affected by your tax rate, the table below can help illustrate the impact of taxes on your net return.

Who Should Favor Munis?

• High-income earners looking to minimize taxable income

• Residents of high-tax states like California, New York, or New Jersey

• Investors in taxable accounts (versus IRAs, Roths, or 401(k)s where tax deferral matters more)

For lower-income investors or those investing inside tax-advantaged accounts, taxable bonds might still offer better raw returns.

Bottom Line

Municipal bonds can be powerful tools for tax-efficient income, especially for investors in higher tax brackets.

Remember, it’s not what you earn, but what you keep that truly matters.