The benefit of bonds is that they have the potential to offer a reliable stream of income via regular interest payments. And while corporate bonds (those issued by companies) are a more common investment choice than municipal bonds (those issued by cities, states, townships, and the like), the benefit of municipal bonds is that their interest is always exempt from federal taxes. Corporate bond interest, on the other hand, is taxable, but corporate bonds tend to offer higher rates. To see which option makes the most sense for your portfolio, you'll need to figure out your tax-equivalent yield.
A tax-equivalent yield is the pre-tax yield that a taxable bond must offer in order to equal the yield of a tax-free municipal bond. It's a formula that takes your federal tax bracket into account to help you determine which type of bond is your best option for generating interest income.
Municipal bonds vs. corporate bonds
Unlike corporate bonds, which are used to raise capital for large corporations, municipal bonds are debt instruments issued by localities to fund public projects or provide public services. The primary benefit of municipal bonds is that the interest they pay is always tax-exempt at the federal level. Furthermore, if you buy municipal bonds issued by your home state, the interest payments you receive are exempt from state and local taxes as well.
While corporate bond interest is always taxable, at a certain point, it pays to take a hit tax-wise if it means coming away with more money in your pocket overall. To figure out which direction to choose, you'll need to calculate your tax-equivalent yield, which will help you compare a taxable yield to one that isn't subject to taxes.
Calculating tax-equivalent yield
To calculate tax-equivalent yield, you'll need to know your marginal tax rate, which is the tax rate you pay on your last dollar of taxable income. With that in mind, you can use the following formula to figure a tax-equivalent yield:
Tax-equivalent yield = tax-exempt yield / (1 - marginal tax rate)
Let's say you're looking at a tax-free bond with a 4% yield and your marginal tax bracket is 25%. In this case, your tax-equivalent yield would be 5.33%, which means paying taxes on a bond with that yield would be the same as getting 4% interest tax-free.
If you'd rather not crunch the numbers every time you're presented with a municipal bond investment, you can use our handy online calculator to figure out your tax-equivalent yield.
Always consider bond ratings
While calculating your tax-equivalent yield can help you determine whether it pays to go with a taxable corporate bond or a tax-free municipal bond, you should always keep your bonds' credit ratings in mind. A credit rating measures a bond's likelihood of upholding its financial obligations. Or, to put it another way, it's a way of determining how risky an investment is. Typically, the lower a bond's credit rating, the higher its interest rate will be, because investors will need to be compensated for taking on the added risk.
It's for this reason that the tax-equivalent yield formula is most useful when comparing two similarly rated bonds. Assuming your marginal tax rate is 25%, if you're looking at a tax-free municipal bond paying 4% versus a taxable corporate bond paying 6% and both have the same rating, you'll probably come out ahead by going with the corporate option. But if that corporate bond has a lower credit rating, you'll need to think about the risk you're taking on in exchange for a slightly higher yield and profit. In many cases, it pays to choose a bond with a lower yield if its issuer is more likely to make ongoing payments -- because if an issuer defaults on your bonds, you won't make any money at all.
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