Interactive Brokers’ senior market analyst Steven Levine explores how to compare the yields of a taxable corporate bond with a tax-exempt municipal security on both an in-state and out-of-state basis. This due diligence lesson is the second of three parts in the U.S. Municipal Bond Market video series, available at IBKR Traders’ Academy.
Please keep in mind that the information in this presentation is provided for informational purposes and should not be relied on for tax, legal or accounting advice. Before engaging in any transaction, you should consult your own tax, legal and accounting advisors.
Municipal bonds are not generally subject to federal tax, and typically, if an in-state, taxpaying resident purchases a muni issued by an entity of that same state, then that resident would also be exempt from state and local taxes on that issuance. However, if a resident of, say, Iowa sets out to purchase a Maine GO, then state and local taxes would apply.
Meanwhile, corporate bonds are subject to both federal and state taxes.
Please note that the following yield comparison calculation examples involve knowledge of your tax bracket.
1. Find the net, after-tax yield of a corporate bond:
Let’s take a 5.0% Maine GO and compare it to a similar-maturity 2.45% Colgate-Palmolive bond, and for simplicity, we’ll compare both at par. Let’s also say for illustration purposes that your tax bracket is 22%.
To determine the net, after-tax return of the corporate bond, first subtract the illustrative tax bracket from 100%, giving 78%. Then, multiply this by the corporate bond’s coupon.
We can then say that this Colgate-Palmolive bond is equivalent to a municipal bond yielding a little more than 1.9%.
2. Find the taxable equivalent yield of a municipal bond (in-state):
If a Maine resident in the 22% tax bracket buys a 5.0% Maine GO at par, there is no state tax applied since it is an in-state purchase.
The 5% bond is divided by 78% to give a taxable equivalent yield.
3. Find the taxable equivalent yield of a municipal bond (out-of-state):
Now, if a taxpayer residing in a different state, say Iowa, purchased the bond, and was, again for illustrative purposes, subject to a 2% state tax, then the federal and state taxes would be combined and subtracted from 100%. We would then divide 5% by 76%.
4. Compare yields across instruments:
If the Colgate-Palmolive bond yielded 6% at par, the 5% Maine GO used in the calculations above would offer a higher tax-equivalent yield in both the in-state and out-of-state cases.
However, as described above, at 1.91%, the Colgate-Palmolive bond is far more expensive than the 5.0% Maine GO yielding 6.41% (in-state) and 6.58% (out-of-state).
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