Drew O’Neil discusses fixed income market conditions and offers insight for bond investors.
One of the major benefits of municipal bonds is that the interest earned is exempt from federal income taxes. The appeal of earning money that you do not have to pay taxes on understandably piques the interest of many investors. That being said, it doesn’t mean that every investor should seek out tax-free bonds for their portfolio. In many situations and for many investors, it makes sense to invest in a taxable product when the “take-home pay” on a bond after paying taxes exceeds what could be earned with a tax-free investment.
Generally, tax-free bonds are going to offer a lower nominal yield than comparable taxable bonds as the tax-free nature “compensates” investors, making the lower nominal yield relatively attractive on a taxable-equivalent yield basis. Deciding whether tax-free bonds or taxable bonds make the most sense depends on a range of factors including current market conditions and an investor’s personal situation (goals, risk tolerance, tax bracket, etc.). An investor’s tax bracket is a major determining factor in choosing between municipal bonds and taxable bonds. The higher the tax bracket, the more beneficial a tax-free investment. Conversely, lower tax-bracket investors receive less benefit from a tax-free investment and therefore are generally better served purchasing a higher yielding taxable product and paying their relatively low tax rate on the income earned.
This chart shows a range of hypothetical portfolios comparing corporate bond yields versus municipal taxable equivalent yields assuming a 24% federal tax bracket. What’s shown generally would be expected: a lower tax bracket investor’s “take-home pay” will be higher with a corporate bond portfolio than it would be with a municipal bond portfolio. While these numbers show the reality of the market, sometimes investors make choices based more on emotion than math. It is fairly common for investors to seek out a tax-exempt municipal portfolio even though they are in a lower tax bracket, simply because they do not want to pay any taxes. At the end of the day, this is generally not in their best interest from a return perspective. To put it another way: would you rather make $500,000 a year and pay no taxes or make $1,000,000 a year and pay $400,000 in taxes?
