What is Tax Equivalent Yield and Why Does It Matter?
Bonds are an important part of any investment portfolio and contribute a valuable element of diversification since stocks and bonds are negatively correlated. An allocation to bonds in a portfolio can help reduce overall portfolio risk. Fixed income instruments also produce a steady stream of income through coupon payments.
But bonds come in a variety of flavors and it’s important to understand the nuances, particularly the tax implications, involved in fixed income investing. Bonds may be taxable or tax-exempt, and tax-equivalent yield helps investors compare returns between taxable and tax-exempt instruments to make informed investment decisions.
Corporate vs Municipal Bonds
A bond, a type of fixed income instrument, represents a loan made to a borrower by an investor. Corporations issue bonds, as do the federal government, states, and municipalities.
Companies issue bonds to raise capital for many different purposes, ranging from building new facilities and investing in new equipment to funding operations and growing their businesses.
Bonds are issued at par, or face value, and pay a specified amount of interest in annual or semi-annual coupon payments. When the bond matures, the investor receives the face value of the bond. Investors who purchase corporate bonds pay taxes on interest income and capital gains.
Municipal bonds are issued by state and municipal governments to finance operating expenditures, fund capital projects, and support public institutions and public works projects.
Municipal bonds are tax-exempt investments, and municipal bondholders do not pay federal income tax on interest income. Municipal bonds may also be exempt from state and local taxes if the bondholder is a tax resident in the issuing state.
Tax Yield Income Defined
When making an investment decision, investors need to look at bond yields with tax implications in mind. The tax equivalent yield tells investors what yield, or return, would be required on a taxable bond to equal the yield on a comparable tax-exempt municipal bond.
Understanding Bond Yields and Taxation
Yield is the return an investor expects to receive over each year a bond is held until maturity. If the investor is holding a corporate bond, interest will always be subject to tax.
As mentioned above, muni bonds are exempt from federal taxes and may be exempt from state taxes under certain conditions (when the bondholder is a resident taxpayer in the issuing state). Treasury bonds issued by the U.S. government are taxed at the federal level but exempt from state and local tax.
Coupon payments are taxed, and if bonds are sold at a profit prior to maturity the holder may be subject to capital gains tax as well.
Calculating the Tax Equivalent Yield Formula
To calculate the tax equivalent yield, you need to know the yield on the tax-exempt municipal bond and your marginal income tax rate. With this information, you can calculate the tax equivalent yield using the following formula:
Say for example that you are considering two bonds, a taxable corporate bond that offers a 4.75% yield and a tax-exempt municipal bond that offers a yield of 4%. You are in the 24% tax bracket.
4% / (1 – 0.24) = 5.26%
A tax equivalent yield of 5.26% means that you would have to choose a taxable bond yielding 5.26% to enjoy the same after-tax yield as the municipal bond. The tax equivalent yield on the municipal bond is 0.51% higher than the yield of the taxable bond. Therefore, you should buy the municipal bond.
The higher your income and tax bracket, and the higher the yield on the municipal bond, the more the taxable corporate bond will need to yield.
Bond Yields and Risk
As with any investment, risk and return are correlated in the fixed income universe. Credit rating agencies such as Standard & Poor’s and Fitch assign credit ratings to borrowers. Each agency has its own designation.
The AAA rating indicates the highest level of creditworthiness, and bonds ranging from AAA to BBB are designated as investment grade. Bonds with lower ratings fall into the “high yield” or “junk” category and are considered speculative with a significantly higher level of default.
Municipal bonds are generally lower risk instruments, although that is not always the case, and consequently yields are lower.
When comparing a muni to a corporate bond, it’s important to compare bonds with similar credit ratings. A high yield bond may have an expected return significantly higher than the tax equivalent yield, but the higher yield comes at vastly greater risk.
Some Municipal Bonds are Also Exempt from State Taxes
Municipal bonds can sometimes be free from state income tax as well as federal income tax. When an investor purchases a muni bond issued by the state where they are a tax resident, they can also benefit from a state tax exemption.
When this is the case, the investor should add the state income tax rate to their federal tax rate to determine tax equivalent yield.
For example, assume you are a New York state resident in the 24% federal income tax bracket. The New York state income tax rate is 6.85%. Therefore, the total tax rate you should use for the tax equivalent yield calculation is 30.85%.
Let’s compare a taxable bond with a 5% yield to a tax-exempt bond with a 4.5% yield. Using the combined tax rate of 30.85%, the tax equivalent yield is calculated as:
4.5% / (1 – .3085) = 6.5%
The tax equivalent yield of the tax-exempt municipal bond is 6.5%, which is 1.5% greater than the yield on the taxable bond. With a tax equivalent yield of 6.5%, the greater value of a bond exempt from both state and federal taxes is highlighted. Understanding this is important when financial planning.
A Municipal Bond is an Attractive Option for Investors in High Tax Brackets
For investors in high tax brackets, the tax benefits from muni bonds can contribute to reducing tax liability.
This is particularly true for those in the four highest tax brackets, as these taxpayers are subject to a 3.80% federal tax surcharge, the Net Investment Income Surcharge, which is used to finance Medicare. Happily, the interest income from municipal bonds isn’t subject to the surtax.
Comparing the yield of a taxable bond to that of a tax-exempt bond is misleading since the taxable bond yield doesn’t take tax liability into account.
Any investor considering an investment in muni bonds, especially an investor in a high tax bracket, should always calculate the tax equivalent yield to make sure they’re comparing apples to apples and making an informed investment decision.
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