Investors buy bonds mainly because the interest bonds earn provides current income, usually with less risk than investment vehicles like stocks. To decide which bonds are the best investments, you have to compare the annual yields you expect to get. However, some bonds offer tax advantages that complicate the task of comparing yields.
The interest rate a bond earns is called the coupon rate. A coupon rate is a fixed yearly amount. For example, a bond with a $5,000 face value might pay a coupon of $300, or 6 percent. As a bond issue trades on the bond market, the price often diverges substantially from the face value. Your annual yield may be higher or lower than the coupon rate, depending on how much you actually pay for a bond. Suppose you buy a $5,000 face value bond for $4,000. If the coupon is $300, your expected annual yield is $300 divided by $4,000, or 7.5 percent.
Bond Income and Taxes
The interest bonds pay is considered ordinary income by the Internal Revenue Service (IRS). This means interest is taxed at the marginal tax rate you pay on wages and other ordinary income. Marginal tax rate is the highest percentage federal income tax you pay (your highest tax bracket). Thus, the after-tax yield for a bond is less than the stated yield. However, most bonds issued by state and local governments (collectively called municipal bonds) are exempt from federal income taxes. As a result, the stated yield for a municipal bond is the same as the after-tax yield.
To make a good investment decision, you need a way to compare the annual yields of municipal bonds and of the corporate and Treasury bonds that are subject to federal income taxes. That’s where equivalent yield comes in. The equivalent yield is the annual yield a taxable bond must pay to provide the same after-tax yield as a municipal bond. To find equivalent yield, first subtract your marginal tax rate from 1. Divide the municipal bond yield by the remainder. The answer tells you the minimum yield a taxable bond needs to produce the same after-tax yield as the municipal bond. Suppose your marginal tax rate is 25 percent and a municipal bond has a yield of 4.5 percent. You subtract 0.25 from one and divide the remainder (0.75) into 4.5 percent to get 6 percent. So 6 percent is the equivalent yield needed for a taxable bond compared to this particular municipal bond.
Most states levy income taxes. However, it’s common for states to exempt income from the municipal bonds issued in that state, at least for state residents. This can substantially affect equivalent yield calculations. To factor in exemption from state income tax, add the percentage of the state income tax to your marginal income tax rate before calculating equivalent yield.
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