What are municipal bonds?
Municipal bonds are security instruments issued by local and state governments to raise funds. When you purchase a municipal bond, you are lending money to that entity with a promise to pay interest on it. Typically, the interest is paid in the form of payments that represent a percentage of the amount you lent. When the bonds mature, you will get your money back. You can choose from tax-free and taxable bond types.
Calculating the equivalent taxable yield
The good news is that the calculation process is not too difficult. Here’s how to calculate the equivalent taxable yield in a few steps:
1. Calculate your tax rate’s inverse (1 – your tax rate). If you are paying a 25% tax, the inverse would be (1 – 0.25) = 0.75 or 75%.
2. Divide this amount by the tax-free bond yield to find the equivalent taxable yield. For example, if the bond yields 3%, use (3.0 / 0.75) = 4%.
If you plugged different tax rates into the above equation, you would see that the higher your tax rate, the higher the equivalent taxable yield, demonstrating that tax-free bonds are best suited for investors in higher tax brackets.
The municipal bonds issued in your state may be tax-free at both the federal and state levels and are known as “double tax-free”.
Comparing bond issues
With your understanding of the subject, you can now make a direct comparison between taxable bonds and tax-free bonds. Your previous calculation showed that the yield on the equivalent taxable bond is 4%.
If you find a taxable bond of the same credit quality and the same time to maturity that offers a yield higher than 4%, it is better to invest in the taxable bond rather than the municipal bond you are comparing it to.
Additional complexities
First, U.S. government bonds are tax-free at the state level. If you are comparing a municipal bond to a government bond, you should take the yield to maturity on the government bond at the time of purchase and multiply it by (1 – your state tax rate).
Second, if you sell an individual bond before it matures, or if you buy a bond fund and sell it again, you will be liable for capital gains tax. While the income itself is tax-free, capital gains are not.
Conclusion
It is beneficial to do this simple calculation before buying a municipal bond or a municipal bond fund. Tax-free income sounds like a great idea on paper, but you might miss out on earning a higher after-tax income from your municipal bond investments.
Frequently Asked Questions (FAQs)
Why is the yield to maturity lower than the coupon rate?
If you are trading bonds in the secondary market, you should consider the yield to maturity rather than the coupon rate. The coupon rate initially is the same as the yield, but as interest rates change, bond prices and their yields change as well. When the yield is lower than the coupon rate, it means that interest rates have fallen and bond prices have risen since the bond was issued.
What types of bonds are generally expected to have the highest yields?
High yields typically indicate high-risk assets. Therefore, the higher the risk in the bond, the higher the expected returns. High-yield bonds that do not carry an investment-grade credit rating are known as “junk bonds.” If you want to achieve the highest possible return, you can purchase junk bonds, but you should consider the risk of default (failure to pay coupons or the principal investment).
Thank you
To use the information provided by The Balance. We hope this information helps you understand how to calculate the tax-equivalent yield on municipal bonds and compare it with other bonds.
Source: https://www.thebalancemoney.com/calculating-tax-equivalent-yield-417147
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