The return on a tax-exempt municipal bond is considered to be equivalent to the return on a taxable bond. Hence the return on a taxable bond must be equal to or greater than the return on a tax-exempt municipal bond. If you want to determine whether or not municipal bonds are a good addition to your investment portfolio in comparison to other types of bonds, one of the most important things you need to know is how to calculate the TEY on municipal bonds.
What exactly are local government bonds?
Before moving on to the math, it would be beneficial to have a brief review of municipal bonds (also known as "munis") and how they function. Municipal bonds, also known as munis, are a type of debt security that can be issued by state and local governments. When you buy a bond, you are essentially lending money to the issuer of the bond with the expectation that you will be repaid with interest. The interest is often paid back in installments that are calculated as a proportion of the total amount that was borrowed. When the bonds reach their maturity date, you will be given your initial investment back. You have the option of purchasing bonds that are exempt from taxes or bonds that are subject to taxes. The tax equivalent yield, often known as TEY, is the metric that is utilized in the process of comparing tax-exempt municipal bonds to taxable bonds. At first glance, the fact that the majority of municipal bonds are exempt from taxation on both the federal and state levels seems like an incredible benefit. When you have the ability to avoid paying taxes on the income from your investments, you do not want to do so. To our regret, though, it is not quite as straightforward as that. Investing in taxable bonds can be profitable for taxpayers in lower tax brackets because these bonds often offer higher yields before accounting for taxes than the returns on tax-exempt municipal bonds. The first thing you need to do in order to make a comparison and figure out whether or not munis meet your requirements is to learn how to compute the TEY.Calculating Tax Equivalent Yield
The encouraging thing is that the calculation won't take too much time. The TEY can be determined in a few simple steps, which are as follows: Determine the reciprocal of your tax rate, which is equal to one minus your tax rate. If you pay taxes at a rate of 25 percent, your reciprocal rate would be calculated as 1 minus 0.25, which is 0.75, or 75 percent. To get the tax equivalent yield, simply divide this amount by the yield on the tax-free bond. For instance, if the bond in question has a yield of 3 percent, you would calculate it as follows: (3.0 /.75) = 4 percent. If you insert different tax rates into the calculation that was just presented, you will notice that the higher your tax rate, the greater the TEY will be. This demonstrates how tax-free bonds are best suited for investors who are in the higher tax brackets. "Double tax-free" refers to the situation in which municipal bonds that are issued within your state of residence are exempt from taxes not only on the federal level but also on the state level. When calculating your reciprocal in Step 1 of the tax-equivalent calculation, be sure to take into account the income tax rate that is in effect in your state. For instance, if your federal tax rate is 25 percent and your state tax rate is 3 percent, the acceptable math for Step 1 would be (1 -.28) =.72. This would be the result of subtracting your federal tax rate from your state tax rate.A Comparison of Different Bond Issues
Now that you have this knowledge, you are in a position to make a comparison that is fair and accurate between taxable and tax-exempt bond issues. Based on your earlier estimate, it was found that the yield on an equivalent taxable bond is 4%. If you can discover a taxable bond with the same credit rating and the same amount of time till maturity that yields more than 4 percent, then you would be better off investing in the taxable bond rather than the municipal bond that you are comparing it to.Two more creases on the surface
To begin, investments in U.S. Treasuries are exempt from state income taxes. When comparing a municipal bond to an issue of the Treasury, you need to take the yield to maturity of the Treasury issue at the time of purchase and multiply it by (1 minus the tax rate in your state). This will give you the yield on the municipal bond. Second, you are going to be responsible for paying capital gains tax if you sell an individual bond before it matures or if you buy a bond fund and then sell it again. Even if there is no tax on the income itself, there is still a tax on any capital gains.The Crux of the Matter
Before investing money in a municipal bond or fund comprised of municipal bonds, it is advisable to perform the following calculation. You may be missing out on the opportunity to make a higher income after taxes with your municipal bond investments because of the tax exemption on your income, which sounds like a fantastic concept on paper.Questions That Are Typically Asked (FAQs)
Why would the yield to maturity of a bond be lower than the coupon rate on the bond?
When trading bonds on the secondary market, you should focus more on the yield to maturity than the coupon rate. This is because the coupon rate might change at any time. Initially, the coupon rate and the yield are the same things, but as the overall interest rate environment shifts, the price of the bond and the yield on it shift as well. When the yield on a bond is lower than the coupon rate of the bond, it indicates that interest rates have declined since the bond was initially issued, while at the same time, bond prices have climbed.Which bonds are typically considered to offer the highest yields, according to market expectations?
Greater levels of risk are often associated with higher yields. Therefore, you might expect a higher yield from the bond if it carries a higher level of risk. "Junk bonds" are another name for high-yield bonds that do not have a credit rating that is considered investment-grade. Investing in trash bonds is the way to go if you are looking for the best yield available; however, you need to be aware of the possibility of default (potentially missing payments or losing your principal investment).