There may be tax advantages with the coupon payments
An alternative to treasury bonds are municipal bonds which are issued not only by municipalities, but can also be issued by universities, airports and hospitals.
The coupon payments from municipal bonds are generally exempt from federal taxes and these bonds are popular amongst bond investors who benefit from the tax exemption. However municipal bonds may still subject to local state tax, especially if the municipal bonds are purchased by investors living outside the state of issue. Also capital gains tax still applies if a municipal bond is sold for a capital gain.
Municipal bonds generally pay a lower interest rate than treasury bonds of the same maturity and they are not backed by the federal government.
The associated risk with municipal bonds depends on the issuer. Municipal bonds issued by municipalities are the safest bonds as they have the power to increase local taxes in order to meet their bond obligations. The municipal bonds issued by universities, airports and hospitals are the higher risk bonds as these issuers rely on revenue generated to meet their bond obligations.
Thus municipal bonds do carry some risk of default (especially the non-municipality issued bonds) and there is a chance that bondholders may not receive their interest payments and may lose their principle.
In a low interest environment municipal bonds pay around one percentage point less than treasury bonds, but there is no federal tax. Whether this lower interest rate which is tax free translates into a higher or lower net return depends on the individual investor’s personal tax circumstances. Bond investors generally hold municipal bonds in taxable accounts and tend to avoid placing municipal bonds into tax-deferred accounts such as an individual retirement account (IRA or Roth IRA).
Due to the federal tax exemption, municipal bonds are the only bond type which is more popular with individual investors than they are with the institutions (such as banks, insurance companies and mutual funds).
Municipal bonds are popular with retail investors,
thanks to the federal tax exemption
Similar to corporate bonds, municipal bonds are often callable, which means that the bond may be recalled before maturity and the principle repaid. The specifications for the bond contract states whether the bond is callable.
The main reason callable municipal bonds are recalled is when interest rates drop and the bond issuer can simply recall their old bonds and issue new bonds at a lower interest rate. Thus the bondholder only ever gets recalled when it’s the most inconvenient to them. The bondholder loses their high interest paying bonds and they can now only invest in the lower interest paying bonds. Callable municipal bonds typically pay a slightly higher interest than non-callable bonds in order to attract investors.
Similar to corporate bonds, municipal bonds are also accessed for their credit risk based on the financial strength of the issuer and they are assigned a credit rating. However not all municipal bonds are rated.
As a general rule, the lower credit rating municipal bonds provide a slightly higher interest rate, but the risk of default also increases.
Municipal bonds are dominated by the retail public and are significantly more volatile than treasury bonds. While this makes no difference to investors holding their bonds until maturity, the volatility is an issue for investors selling their bonds before maturity as retail investors typically sell when market conditions are worst. The volatility is due to the relatively low liquidity of municipal bonds and an investor may not even be able to sell their bond. Again this is not a problem if the investor holds their municipal bond until maturity.