Comparison To Corporate Bonds
Because municipal bonds are most often tax-exempt, comparing the coupon rates of municipal bonds to corporate or other taxable bonds can be misleading. Taxes reduce the net income on taxable bonds, meaning that a tax-exempt municipal bond has a higher after-tax yield than a corporate bond with the same coupon rate.
This relationship can be represented mathematically, as follows:
where
- rm = interest rate of municipal bond
- rc = interest rate of comparable corporate bond
- t = tax rate
For example if rc = 10% and t = 38%, then
A municipal bond that pays 6.2% therefore generates equal interest income after taxes as a corporate bond that pays 10% (assuming all else is equal).
The marginal tax rate t at which an investor is indifferent between holding a corporate bond yielding rc and a municipal bond yielding rm is:
All investors facing a marginal rate greater than t are better off investing in the municipal bond than in the corporate bond.
Alternatively, one can calculate the taxable equivalent yield of a municipal bond and compare it to the yield of a corporate bond as follows:
Because longer maturity municipal bonds tend to offer significantly higher after-tax yields than corporate bonds with the same credit rating and maturity, investors in higher tax brackets may be motivated to arbitrage municipal bonds against corporate bonds using a strategy called municipal bond arbitrage.
Some municipal bonds are insured by monoline insurers that take on the credit risk of these bonds for a small fee.
Read more about this topic: Municipal Bond
Famous quotes containing the words comparison to, comparison, corporate and/or bonds:
“In comparison to the French Revolution, the American Revolution has come to seem a parochial and rather dull event. This, despite the fact that the American Revolution was successful—realizing the purposes of the revolutionaries and establishing a durable political regime—while the French Revolution was a resounding failure, devouring its own children and leading to an imperial despotism, followed by an eventual restoration of the monarchy.”
—Irving Kristol (b. 1920)
“Envy and jealousy are the private parts of the human soul. Perhaps the comparison can be extended.”
—Friedrich Nietzsche (1844–1900)
“The generation of women before us who rushed to fill the corporate ranks altered our expectations of what working motherhood could be, tempered our ambition, and exploded the supermom myth many of us held dear.”
—Melinda M. Marshall (20th century)
“My Christian friends, in bonds of love, whose hearts in sweetest union join,
Your friendship’s like a drawing band, yet we must take the parting hand.
Your company’s sweet, your union dear; Your words delightful to my ear,
Yet when I see that we must part, You draw like cords around my heart.”
—John Blain (18th century)