Most well-allocated investment portfolios contain bonds as a key component. Two common types of bonds that are often considered for a portfolio are tax-exempt bonds (municipals) and taxable bonds (corporates or Treasuries). The difference in tax treatment between tax-exempt and taxable bonds is a major differentiator, however, that affects their yields and one that every investor should carefully consider.
As a refresher, tax-exempt bonds are generally free from federal income tax. In addition, if the bond is issued by your home state, it is usually free from state tax as well. Similarly, if the bonds are issued by a local municipality e.g., New York City, they are usually tax-free for city residents who purchase those bonds. There are several different types of tax-exempt bonds, including General Obligation (G.O.) bonds that are backed by the credit as well as the taxing authority of a municipality; and revenue bonds, supported by the income generated by the issuing utility, service, or project.
Tax-exempt bonds are rated by the rating agencies (Standard & Poor’s, Moody’s, or Fitch) according to their creditworthiness. Some tax-exempt bonds are insured by a third-party insurer, which automatically boosts their rating to AAA — the highest — since the repayment of all the principal and interest is guaranteed to the bondholder, even in the event of the issuer’s default. Insured bonds usually have a lower yield than comparable uninsured bonds.
Taxable bonds, on the other hand, are subject to federal and state tax and are typically backed by the issuing company’s future income. Similar to tax-exempt bonds, the credit quality of corporates is rated by the rating agencies and generally speaking, their yields are most often higher than tax-exempt bonds. However, in order to do an ‘apples to apples’ comparison on the yields of taxable vs. tax-exempt bonds, you must factor in the effect of income taxes.
Use This Mathematical Calculation
There is a longstanding formula that has been used by advisors and investors to determine the taxable equivalent yield of a tax-exempt bond:
Taxable Equivalent Yield = Tax-exempt yield / 1 – [tax bracket]
For example, if the tax-exempt yield of the municipal bond you are looking at is 4% and you are in the 25% tax bracket, this is how the formula would work:
4%/1-0.25 = 5.33%
So a comparable taxable bond would have to yield 5.3% to equal the return of a 4% tax-exempt bond.
In general, tax-exempt bonds will be beneficial for investors in higher tax brackets. There’s more than meets the eye, however, than the underlying yield of a bond. Your financial advisor can provide guidance about which bonds are best for your portfolio considering your specific situation and goals and your income.