Municipal bonds are bonds issued by municipal entities such as cities, states, library districts, school districts, etc. For decades, most municipal bond interest has been federally tax exempt, ie, an individual pays no Federal tax on the interest they receive from owning a municipal bond. State tax on municipal bond interest varies according to the state. These types of bonds are readily available in liquid ETF or CEF wrappers like MUB, HYD, and MUI.
Understanding tax-equivalent yield
Because the interest earned from municipal bonds is federally tax exempt, that interest is worth more to investors than interest earned from corporate or government bonds. For example, if a person in the 30% tax bracket earns 4% interest on $100,000 of municipal bonds, and pays no tax on that interest, they keep all $4,000. If that same person earns 4% interest on corporate bonds, and pays 30% in taxes, that person is left with only $2800 ($4,000 – (30% * $4000) = $2800. So the tax-free paid bond 4% ($4,000/$100,000 = 4%) and the taxable bond paid 2.80% ($2,800/$100,000 = 2.80%).
A quick measurement used in the bond industry is Tax Equivalent Yield. This is defined as the bond interest one would need on a taxable bond just to end up with the same amount of money one would get from a municipal bond.
Let’s take Sam. Sam is in the 30% tax bracket and sees two bonds available in the market: a AA rated municipal bond due in 10 years at 4% and a AA corporate bond due in 10 years at 5%. One method of comparing the net yields on the bonds is Taxable Equivalent Yield (TEY). TEY is the yield one would need on a taxable bond in order to match the tax exempt municipal bond yield. That equation looks like this:
Municipal Bond yield/(100 – tax bracket) = taxable equivalent yield
In Sam’s case, she took 4 / (100 – 30) and got 5.71. So, Sam would need at least 5.71% on a taxable bond just to equal the 4% tax free yield she could get on a municipal bond. In her case, the corporate bond at 5% actually nets her LESS MONEY after taxes than the municipal bond at 4%.
From a tax standpoint, sometimes municipal bonds make sense to buy, and sometimes they don’t make any sense at all. Anyone managing a bond portfolio should keep a close watch on tax equivalent yields and what taxable bonds are yielding for the same maturity as the municipal bonds.
We’d welcome any questions you might have on your bond portfolio.
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