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Yield is of critical importance when selecting investments, especially the bonds that typically play the role of income generation and stability in a portfolio. The yield on an investment is expressed as a percentage. A 3% yield means that a $100,000 investment pays $3,000 of interest. This is a simple calculation, but we should go a little further to answer the question of ‘What do I keep’ or ‘What can I spend?’. Depending on the bond and the investor’s tax situation, the answer can range from ‘All of the interest’ to a less exciting ‘Half or less’. For many investors this calculation is changing now that tax rules and brackets have changed, and for some investors it’s time think about changing their bond investments.
For an example, let’s compare two large bond funds with different yields and tax treatment. We will look at a short-term municipal bond fund, the iShares Short-Term National Muni Bond ETF and a short-term corporate bond fund, the iShares Short-Term Corporate Bond ETF. To compare the yields, the finance industry uses a measure called taxable-equivalent yield, which answers the question ‘What would the taxable bond have to pay so that I keep the same amount as I keep from the tax-free bond?’
Here is an example for an investing couple with $200,000 taxable income (similar to an individual with $100,000 taxable income). Their Federal tax bracket is now 24%.
Short-Term Corporate Bond ETF
Distribution Yield as of 3/25/19: 3.48%
After-tax Yield: 2.64%
Calculation: 76% of 3.48% i.e. 24% is lost to tax
Short-Term National Muni Bond ETF
Distribution Yield as of 3/25/19: 1.83%
Taxable Equivalent Yield: 2.41%
Calculation: 1.83% / (1 – 0.24) i.e. increase the yield to account for how much tax you get to keep given the tax-free nature of the bond income
In this example, the investor would keep more from the taxable bond fund. It actually takes a tax rate of 48% to keep more of the interest on an after-tax basis from the muni bond fund. An example of a taxpayer with a bracket that high is income above $600,000 (37% Federal bracket + 3.8% Medicare investment income tax) plus state and local income taxes over 8%. Relatively few taxpayers are in such high brackets. Factors that contribute to this situation include falling Federal tax brackets and rising taxable bond yields. Perhaps surprisingly, even though total taxes due have risen for many investors in high tax states who are losing deductions, the tax rate they face on their bond income may have actually fallen.
When we decide in which bonds to invest, this is one important factor among several. Other considerations include credit quality, maturity, potential calls, and volatility. The two funds mentioned here vary somewhat in all of these metrics. Furthermore, the current tax brackets are only in their second year, and history shows that they will eventually change again. Each investment is a personal decision that planning can help inform.
IMPORTANT: Results may vary over time. Results of this discussion are neither guarantees nor projections of future results. Information is for illustrative purposes only. Yields, pricing and tax rates will change over time and this is not a recommendation. Material discussed herewith is meant for general illustration and/or informational purposes only, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice.