Municipal Bonds: Not all yields are created equal

As investors grow accustomed to lower interest rates, many search for attractive yield in areas never previously considered. For those looking for return for taxable dollars, one area to consider is municipal bonds.

Which investors need municipal bonds?

The progressive nature of today’s federal tax rates plays a role in deciding if municipal bonds are a good fit for investors. Even investors who aren’t in the top tax bracket can potentially benefit from an investment in municipal bonds. Of course, as each individual’s tax situation is unique, consulting a tax expert before recommending any strategy is advisable. 2016 marginal taxable invesetment income rates As the exhibit above highlights, investors should not overlook the Net Income Investment Tax (NIIT) – the 3.8% Medicare surtax tied to investment income such as interest income, capital gains, dividends, etc. For a married couple filing jointly (MFJ), the NIIT kicks in when modified adjusted gross income exceeds $250,000. But even for clients earning much less, managing the impact of taxes can make a meaningful difference. A married couple (MFJ) reaches the 25% tax rate for any taxable income above $75,301. Think about that. For every dollar of interest income (usually taxed as ordinary income at one’s top marginal rate), 25 cents—or ¼--every dollar of income goes to Uncle Sam. In some cases an additional amount also goes to state taxes. For some investors, municipal bonds can help reduce that tax burden.

Understanding tax equivalent yield

To see if municipal bonds may be advantageous for a particular investor, look at the tax equivalent yield (TEY). The TEY helps compare taxable income vs. tax-free income. Note, you need to know your client’s federal and state marginal tax rate (the tax percentage on the next dollar earned). Tax Equivalent Yield =      SEC Stated Yield                                       (1 – Marginal Tax Rate) For example, let’s look at a mutual fund with a stated 30-Day SEC Yield of 3.0%. Let’s also assume the investor has the pleasure of being in the top federal tax rate of 39.6%. Add in the 3.8% for NIIT and you get a marginal rate of 43.4%. Tax Equivalent Yield =        3.0%     =   5.3%                                       (1 – 43.4%) In this example, an investor would need to earn at least a 5.3% yield on a taxable bond fund to get the tax equivalent yield for a municipal bond fund. That could be challenging in today’s low yield environment. If we assume the investor is in the 25% tax bracket, the tax equivalent yield increases to 4.0% - still a material improvement. Tax Equivalent Yield Of course, the comparison is not just about comparing yield. Be sure to consider the following factors:
  • Contingent risks between the two options (credit risk, interest rate, etc.)
  • The role in a diversified portfolio
  • Asset location choices between taxable and non-taxable portfolios
  • The goals of the investor (do they want/need total return or current income)

Bottom Line

For many investors, today’s low interest rate environment increases the need to consider a wide opportunity set to meet yield requirements. For taxable investors – even those who aren’t in the top tax bracket – municipal bond vehicles may help them reach their outcomes.