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Tax Yield Calculation Can Help You Pick the Right Bond to Buy

Ruchi Gupta - Author
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Jun. 27 2022, Published 8:16 a.m. ET

When it comes to bond investing, what you see isn’t always what you actually get. A tax yield analysis may help you choose between municipal bonds and corporate bonds.

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Bond investing tends to be more popular during uncertain economic times. When the economy slides into a recession, people lose jobs and corporate earnings usually decline. As a result, stocks can tumble and dividends may be at risk of getting slashed or stopped.

Therefore, in a recession, some investors lean on bonds, either to shield their portfolios or to generate income through interest payments. Whereas bonds can provide shelter in rough times, Warren Buffett isn’t a fan of them and recommends index funds instead.

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Bond yields, explained

With bonds, you receive regular interest payments for the period your money is on loan to the government or a private corporation. However, not all bonds are made equal. Depending on factors (such as your credit rating), some bonds offer higher interest rates than others. Additionally, depending on the source, bonds can be taxable or tax exempt.

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How do tax-free bonds work?

If you’ve invested in corporate or U.S. Treasury bonds, interest payments are usually subject to federal income tax. However, some bonds—namely municipal bonds (munis in insider parlance)—aren't. Munis are issued by municipal authorities to raise money to fund public programs. They usually come with lower interest rates, but the yields are shielded from federal income tax and, sometimes, local taxes as well.

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Tax yields in bond investments, explained

A taxable bond that offers an interest rate of 5 percent isn't necessarily better than a tax-exempt bond that offers a 3 percent rate. Conversely, a tax-free bond may not be a better deal than a taxable bond. To find the bond that will maximize your returns, you can do a tax-equivalent yield analysis. This is particularly important step for investors in a high tax bracket.

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Say a tax-exempt bond yielding 3.5 percent earns you $1,000 and you’re in the 20 percent tax bracket. You’d keep all that money because the tax doesn’t apply. But if a taxable bond with a 5 percent yield earns you $1,000 and you’re in the 20 percent tax bracket, then you only take home $800. A higher yield doesn’t automatically translate to higher earnings once you take care of taxes.

If you performed a tax-equivalent yield calculation, you’d know the right place to be. The tax yield measure lets you know the type of return that a taxable bond needs to provide to match a comparable tax-free bond. You calculate it by dividing the tax-exempt bond yield and dividing it with one minus your income tax rate. Tax yield analysis can help you make smart bond investment decisions.

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