It’s all about the Math.
One of the characteristics of Municipal Bonds that make this an attractive asset class is the taxable-equivalent yield they provide.
Looking at Taxable-Equivalent Yield
Comparing taxable-equivalent yield shows clearly the advantage of municipal bond’s tax-free coupon. Simply put, taxable-equivalent yield is calculated by dividing the yield of an AAA-rated (or even an A-rated) municipal by one minus the current highest personal Federal tax rate (e.g. 37%). The result can then be compared with whatever comparably-rated U.S. Treasury or corporate bond you might otherwise be interested in purchasing.
Here’s an example using figures as of March 9, 2018: The AAA-rated 10-year muni bond yield was 2.49% and the U.S. Treasury 10-year bond yield was 2.89%. Using the formula above, the comparison of taxable equivalency produces a result of 3.95% versus 2.89%. This is a clear 106 basis point advantage from a Federal tax perspective for a municipal bond investment
Nominal vs. Taxable-Equivalent Yields
as of 3/9/2018
It’s important to keep in mind that the above example is representative of someone in the highest marginal federal income tax bracket. Everyone has his/her own taxable equivalent return based on each individual’s own highest marginal federal tax rate. Also, the taxable equivalent rate can be higher if the bonds being purchased are tax-free for state and local tax purposes.
For example, another individual whose highest marginal federal tax rate is only 25% would have a lower taxable equivalent yield. Using the formula and example above, this individual would have a taxable equivalent yield of only 2.24%. In this example, the municipal bond’s tax-free coupon would not be as beneficial as utilizing the U.S. Treasury 10 year bond.
Investors should never overlook this critical, and very simple, piece of analysis. As illustrated above, the benefits of utilizing municipal bond investments in a portfolio is quite compelling for those individuals in the highest marginal federal income tax brackets.
iSectors® Tax-Wise Income Allocation is a model portfolio strategically allocated and managed for tax sensitive investors seeking fixed income for a portion or all of their portfolio. The iSectors® Tax-Wise Income Allocation invests in select municipal bond exchange-traded funds (ETFs) and laddered specific maturity date municipal bond ETFs. The allocation’s average duration is less than 6, with an average investment grade credit rating. Two percent of the portfolio is allocated to money market instruments to provide liquidity and facilitate transactions.
Please review the following profile for more information: iSectors Tax-Wise Income Allocation!