Quizmaster, Doug Hutchinson, presents his quiz for the month. Here, Doug considers whether tax-exempt municipal bonds are a better investment than corporate bonds.
Consider this Scenario:
Your friend Ricky is considering purchasing a bond and is deciding between a taxable corporate bond and a tax-exempt municipal bond. The taxable bond has a yield to maturity of 4.10% and the tax-exempt municipal bond has a yield to maturity of 3%. Assume both bonds have a similar credit quality and a similar maturity.
Assume that Ricky has a federal tax rate of 25% and a state tax rate of 5% and assume that the interest from the tax exempt municipal bond is exempt from both federal and state income tax.
Which bond will give Ricky the higher after tax yield to maturity??
Solution:
Because of their tax benefits, municipal bonds typically offer lower yields than a taxable security with a similar maturity and credit quality. Your friend Ricky must determine if his tax savings from the municipal bond makes up for the lower yield of the municipal bond.
To determine if the tax savings makes up for the lower yield, we need to calculate the taxable equivalent yield on the tax-exempt municipal bond.
Taxable Equivalent Yield = Tax Free Muni Yield / (1 – [Federal Tax Rate + State Tax Rate (1 – Federal Tax Rate])
Taxable Equivalent Yield = 0.03 / (1 – (0.25+0.05(1 – 0.25))
Taxable Equivalent Yield = 0.03 / 0.7125
Taxable Equivalent Yield = 4.21%
Ricky would have to earn a yield of 4.21% from a taxable investment of equal maturity and similar characteristics to match the tax-exempt yield of 3%.
In this case, Ricky will be better off with tax-exempt bond with a yield of 3% (taxable equivalent yield of 4.21%) than the taxable bond with a 4.10% yield to maturity.
View last month's quiz from Doug: The Cost of Early IRA Withdrawal.
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This quiz is intended for informational and illustrative purposes only. This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.
