Muni bonds can help cushion the bite of taxes

It's important to take tax implications into consideration when investing in bonds. Matt evaluates the potential tax merits of municipal bonds.

In my prior post, I gave an overview of the income options available in today’s bond market, going over how much yield was available from different asset classes and how to think about the risks that different bond investments carry.

But I left out something that is near and dear to all of our wallets: taxes. The reality is that if you hold a bond investment in a taxable account, you will be taxed on the income you receive. And if you are smart about your bond investments, factor this tax into your investment decisions.

Investors holding bond investments in taxable accounts often turn to municipal bonds because of their tax advantage. The income muni bonds generate is not subject to federal income taxes and may not be subject to state and local taxes, depending on who issues the bond and where the investor lives. The question is how to compare the yields of bonds that are subject to income taxes—like corporate bonds—to the yields of municipal bonds. A common way to do this is to gross up a muni bond’s yield by calculating its tax-equivalent yield. Use the equation below to get the tax-equivalent yield of a muni bond.

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The calculation is fairly simple. Take the yield on a muni bond, and adjust it to make it equivalent to a bond that is subject to income tax. For example, if an investor buys a muni bond with a 3% yield and is subject to a 40% federal income tax rate, the tax-equivalent yield would be 3% / (1 – 0.4) = 5%. This means that the yield on this muni bond is equivalent to the after-tax yield on a taxable 5% bond. If a taxable bond has a yield below 5%, the muni bond offers a higher applicable yield. If the taxable bond has a yield above 5%, then it has a higher applicable yield. This calculation is very helpful for understanding the impact of taxes on bond income, making it easier to choose between different bond investments.

Let’s now go back to the income chart I used in the previous post. Only this time I have added municipal bonds to the mix:

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The first bar on the chart is the listed yield on national muni bonds, which you can see is just below 2%. Next to it I have the yield on investment grade credit. I picked this asset class because it is made up of investment grade, taxable corporate bonds. Both the Bloomberg Barclays Municipal Bond Index and Bloomberg Barclays U.S. Corporate Bond Index contain investment grade bonds, but corporate bonds’ income is subject to income taxes. In this example, corporate bonds are yielding 2.8%, which on the surface is much higher than national munis. But what happens when we include taxes?

To answer that question, I added two more columns, each showing the tax-equivalent yield of the municipal bonds yielding 2%, but at different tax rates. The 43.5% tax rate represents the highest federal income tax bracket, inclusive of the HCA surcharge. If an investor is in this bracket, muni bonds offer a much higher tax-equivalent yield than corporate bonds, 3.5% compared to 2.8%.

But most people are not in the top tax bracket. In that case, how do we compare the yields of investment grade and municipal bonds? I can use the formula above to calculate the breakeven tax rate—the rate at which an investor is indifferent, after tax, between holding corporate or muni bonds. In this case this works out to a federal tax rate of 29%. If your tax rate is below 29%, you would be better off with corporate bonds, and if your tax rate is above 29%, municipals would be the way to go.

Reported yields for municipal bond funds usually include a tax-equivalent yield. For example, as of 31 October 2016 the distribution yield for the iShares National Muni Bond ETF (MUB) was 2.01%, while the tax-equivalent distribution yield was 3.56%.

The next time you are looking at a bond investment, consider the possible effects of taxes and use the handy calculation above as a guide for making the right decision.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.

The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by visiting www.iShares.com or www.blackrock.com. For standardized performance of MUB, please click here.

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