Most investors think about fixed-income securities like bonds when they're looking for safer investments that generate income. Bonds can generate a stable rate of return while being largely insulated from stock market volatility.
There are many types of bonds, from corporate bonds to government bonds like Treasury bonds, and even municipal bonds. These types of investments are different from most stocks as they can be used to generate regular, fixed income, as opposed to some increase in value due to capital gains.
Although there are several differences between the different bond types and differences between individual bonds with different issuers and interest rates, perhaps one of the most valuable differences for some investors is their tax treatment. One class of bonds is especially unique in that they're generally exempt from federal and often even state taxes. These bonds are municipal bonds, which are essentially debt instruments used by government agencies to fund public projects.
Here's what investors should know about municipal bonds and how to calculate tax-equivalent yield.
Tax Benefits of Municipal Bonds
Unlike other bond types, interest on municipal bonds and some municipal bond funds are exempt from federal income tax. It might be exempt from state income tax as well if you reside in the state or municipality from which the bond was issued.
Because of these tax breaks, those in higher income brackets might seek these types of bonds in order to avoid paying taxes on the interest that's generated. Even though those in higher tax brackets will see a greater benefit, anyone looking for a fixed income investment can benefit.
The key is to understand how to compare interest rates between tax-exempt investments like municipal bonds and the more common taxable investments. This is where understanding tax-equivalent yield becomes important.
What Is Tax-Equivalent Yield and How Is It Calculated?
Generally speaking, comparing two bonds is easy. All else being equal, the bond with the higher interest rate will yield more money over time. But you can’t simply compare interest rates when looking at tax-exempt bonds as opposed to the more common taxable bonds because you have to account for taxes or, as is the case of municipal bonds, the lack thereof.
Tax-equivalent yield is a way to measure the return on a taxable bond or other investment to make it equal to the return associated with a tax-exempt bond or investment. Calculating tax-equivalent yield allows investors to make an apples-to-apples comparison when weighing municipal bond returns against returns of other investments.
For example, your real rate of return would be less than 3% if you have to pay taxes on the interest when you have a taxable bond that pays 3% interest. So you have to use the following equation in order to compare a taxable investment's rate of return to a nontaxable investment.
Tax-equivalent yield = interest rate ÷ (1 – your tax rate)
Let’s assume you’re in the 24% tax bracket in this example, and you're looking at a municipal bond that has a coupon, or interest rate, of 2.5%. You would perform the following calculation if you want to know the real rate of return on a nontaxable municipal bond—the rate that would be equivalent on a taxable bond.
Tax-equivalent yield = 0.025 ÷ (1 - 0.24), or 0.025 ÷ 0.76 = 3.2895%
You’d need to find a taxable savings account, CD, or bond paying roughly 3.3% or more in order to achieve the same effective rate of return as the 2.5% municipal bond. We only account for the savings in federal taxes in this example. The real rate of return would be that much higher if the municipal bond were also free from state taxes.
Compare Interest Rates Carefully
It's important to make sure you’re comparing income-producing investments appropriately. Although many tax-exempt bonds may appear to have a lower interest rate at first glance, you really won’t be able to determine your real rate of return until you calculate the tax-equivalent yield. This can help you make a more informed decision when determining how to invest if you're attempting to target a specific rate of return in your portfolio.