A common asset that one may invest in is bonds. As of 2022, the World Economic Forum estimates that the global bond market was worth $133T, yes, trillion, with nine zeros. In comparison, the global equity markets were worth $101.2T in 2022 per the Securities Industry and Financial Markets Association. As you might have guessed, with a market that large, bonds can come in all different shapes and sizes, and each type has features that are specific to it. In this article, I will break down the difference between fully taxable bonds, state tax-exempt US treasuries and potentially fully tax-exempt municipal bonds.
Fully taxable bonds.
Taxable bonds are usually corporate bonds, but also may be some form of a government bond. A corporate bond is issued by a company, for example Amazon, to raise capital. A taxable municipal bond is a taxable government bond where the proceeds do not meet certain public purpose or public use tests under IRS requirements. For example, if a pension for a town is underfunded, issuing a bond to raise funding levels will not be a tax-exempt municipal bond. Debt securities in this category will pay out interest fully taxable at the federal and state levels.
State tax-exempt US treasuries.
US Treasuries are a debt obligation issued by the federal government of the US to fund itself. They come in the form of bills (less than 1 year to maturity), notes (1-10 years to maturity), or bonds (10-30 years to maturity). Treasuries are exempt from state taxes but are not exempt from federal taxes. This is true even for zero coupon treasuries. Despite not having an interest payment, imputed interest is calculated and will be taxed each year at a taxpayer's marginal tax rate.
Federally tax-exempt municipal bonds.
Municipal bonds are state and local government bonds used to finance a project that do meet the IRS requirements mentioned previously. An example here may be a courthouse, highway, or water facility. These bonds will pay out interest that is exempt from federal income tax as well as state income tax if it is issued by the state that the bond holder resides in. The taxable equivalent yield (TEY) on these bonds usually adjusts in the marketplace so that the math only works out for the highest income earners to buy them. Some investors may choose to take the lower taxable equivalent yield simply to avoid having to pay tax even though their after-tax return would have been higher. These bonds may make sense for certain investors that want to reduce their taxable investment income.
Key concept – taxable equivalent yield
One key concept to keep in mind when comparing yield of different bonds is the taxable equivalent yield. The taxable equivalent yield is the return that a taxable bond needs to possess for its yield to equal the yield on a comparable tax-exempt municipal bond or US treasury. One can compute this by taking the tax-advantaged yield and dividing it by 1 minus the marginal tax rate. Often the tax-advantaged yields will be lower in the marketplace to account for the fact that it is well, tax-advantaged.
See below for a simplified example:
A fully taxable bond may have a 5.00% yield in the marketplace. There is no adjustment needed here.
A US treasury bond may have a 4.50% yield in the marketplace. One must know their state level marginal tax rate to get the taxable equivalent yield. If the state marginal tax rate is 5%, the calculation would involve taking the 4.50% yield and dividing it by 1 minus .05 or 0.95 to get a taxable equivalent yield. In this case, the TEY would be equal to 4.74%.
A fully exempt municipal bond may have a 4.00% yield in the marketplace. One must know both their federal and state level marginal tax rate to get the taxable equivalent yield if that bond was issued in the same state that the taxpayer lives in. If the taxpayer’s federal marginal tax rate is 30% and state marginal tax rate is 5%, the calculation would take the 4.00% yield and divide it by 1 minus (0.3 plus 0.05) or 0.65 to get a taxable equivalent yield. In this case, the TEY would be equal to 6.15%.
If the bond was issued in a different state than the one a taxpayer lives in, the calculation just needs to be adjusted slightly. Given the same numbers as the example above, the calculation would take the 4.00% yield and divide it by 1 minus 0.3 or 0.7 to get a taxable equivalent yield. To reiterate, not living in the same state as the bond issuance state results in not getting the state tax exemption, so the marginal state tax rate is irrelevant for this calculation. In this case, the TEY would be equal to 5.71%.
By computing taxable equivalent bond yields, it is much easier to compare several types of bonds.
Conclusion
The world of bonds is both large and nuanced at times. Each type of bond may play a specific role for an investor to help them achieve their goals. At times this may mean utilizing one specific type of bond, in other situations it may potentially mean utilizing all three distinct types of bonds with varying weights.