HomeLatest ThreadsGreatest ThreadsForums & GroupsMy SubscriptionsMy Posts
DU Home » Latest Threads » A HERETIC I AM » Journal
Page: 1

A HERETIC I AM

Profile Information

Name: Schmengie
Gender: Male
Hometown: Podunk, FL
Home country: USA
Current location: Various.
Member since: Mon Aug 4, 2003, 02:56 PM
Number of posts: 19,768

Journal Archives

The term "Tax equivalent yield" (TEY) comes to mind. (Edited)

This is the idea that given a certain adjusted gross income, it specifies the difference between what is actually realized via interest paid on taxable bonds versus non-taxable bond interest, specifically municipals.

In other words, you realize the same amount of 'take home pay' so to speak on a 2.5% coupon tax free as you would on a taxable 3.5% (purely an example) bond.

Investopedia defines it thus;


For example, if a tax-free bond has a yield of 20% and the tax rate is 10%, a taxable bond would need a pretax yield of 22.2% (20% / 90%) in order to be considered an equivalent investment. Therefore, all bonds with the same risk but with a pretax yield of less than 22.2% should be considered inferior investments compared to the 20% municipal bond.


A lot of it will depend on your income from interest bearing investments.

Bloomberg.com posts bond yields daily, and though they don't break down to the 3rd or 4th decimal point on their public website (you need a subscription to get more detail), glancing occasionally at their bond page can give you an idea of what is happening;

http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/

Steve, you may be completely familiar with these securities, but for the sake of those not so familiar, I want to make a point or two.

It is important to bear in mind the difference between yield and the coupon rate of a bond.

Looking at the Bloomberg page I linked above, in the first section is listed US Treasuries. As of this writing, the 30 year had a coupon of 3.375%. That means that for every single $1000 par value bond you own you would receive $33.75 per year in interest payments, regardless of what you paid for it. Not that I have a million or anything, but I find it easier to think in those terms, so a million in face value of those would generate $33,750 per year.

The yield on that same bond is showing 3.46%. Why? Because those bonds were selling (quoted) at a discount to that $1000 par value. The "Price" column shows "98-11 1/2". That translates to ninety eight and eleven and a half thirty seconds percent of par. (!) 11 1/2 32's = 0.359375. 98 % of $1000 = $980 therefore those bonds would cost you $983.59 give or take a penny or two. Hold them for 30 years and the US Treasury will give you $1000 back. That difference of $16.41 per bond is only realized at the time the bonds are redeemed, but for the sake of the calculation of total income, that is considered income distributed annually, even though it technically isn't.

Clear?

Now...that coupon rate - the $33.75 per year is TAXABLE interest, even though it is coming from the US Treasury. Scroll down that Bloomberg page and you'll see rates for Munis. They are showing the 30 Muni at a yield of 3.46%, exactly what the 30 Treas is. But why yield and not coupon also? Because they are using an average for all the AAA rated Muni paper out there. There are thousands of different 30 year Muni issues, so they have no choice but to give that average yield. There is only one 30 year Treas.

So.....

The easiest way to figure out the head and tail of all this is to use a TEY calculator. Google offered several, and here's one from Bankrate.com;
http://www.bankrate.com/calculators/retirement/tax-equivalent-yield-calculator-tool.aspx
That tool is asking you to enter the tax free yield and will calculate the taxable rate needed for TEY

Sticking with the 30 year Muni, if I plug in those numbers, a 3.46% yield on a non-taxable bond would require a yield of 4.613 on a fully taxable. Going by what your advisor suggests, if you plug in 2.5% tax free you get 3.33%, so he is real close. As you can see, we aren't anywhere near a 4.6% yield on long Treasury bonds.

I should be clear here that your regular, run of the mill corporate bond would also generate taxable interest.

Now..here's another item or two.

1) There is ABSOLUTELY NO BENEFIT AT ALL to own Municipal bonds inside a tax-deferred account, be it an IRA, a Roth IRA, a 401(k) or a 403(b). Why? Because interest on bonds is paid regularly and you can't access the money in those accounts until retirement without penalty. This is why you just won't see a Municipal bond mutual fund offered in a 401(k) plan. It's pointless. Any advisor that tells you otherwise doesn't know what he is talking about.

2) Even though interest paid on Munis tends* to be tax free, you can still be subject to capital gains taxes on them. Why? Because it is possible to purchase them at a discount to par, just as with the Treasury I cited above, and it doesn't matter to the IRS where it comes from, if you have a capital gain, you have to pay taxes on it. If you buy a bond for $980 and sell it for more, you have realized a capital gain. If I won the lottery for instance, and I wanted to set up a large portfolio of Munis and never pay taxes again, I would have my bond buyer try as best he could to keep the purchase price at or near par. That way there is little or no capital gains when I either redeem or sell one of my bonds.

*Tends = Not all Municipal bonds pay tax-free interest. It depends on the state where you live and the type of bond. If you live in one of the 7 states with no state income tax, it doesn't matter, but if you live in all the rest, the only bonds that typically pay tax free interest are those issued in your home state. If you live in say...Michigan and own a California Muni, Michigan doesn't care and they want their cut of your income. (I noticed the OP is a FL resident, so this point is moot) So called "Private use" munis - things like bonds for a stadium or a commercial development are often not tax exempt because the end purpose is private use, even though the city or county may have initiated the bond offering.

This website has a pretty good tool for looking up bonds from various issuers, both corporate and municipal;
http://finra-markets.morningstar.com/BondCenter/Screener.jsp?type=advanced

Just for giggles, open that link, high lite the "Corporate" radio button under "Advanced Search", don't fill anything else in and hit "Show Results". You'll get well over 1500 pages! If you aren't clear on how to read the results of a search, just let me know and I'll break it down for you.

I hope all of the above was of some help. If you have any further questions, please feel free to ask, and once again, I apologize for the delay in responding.



Edit here;

I want to be sure to emphasize that the comparison I have made between Munis and US Treasuries is not the only applicable one. The TEY calculator applies to basically any taxable vs. non-taxable bond comparison.
Posted by A HERETIC I AM | Sun May 11, 2014, 11:42 AM (1 replies)
Go to Page: 1