Municipal Bond - Comparison To Corporate Bonds

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

• r_m = interest rate of municipal bond
• r_c = interest rate of comparable corporate bond
• t = tax rate

For example if r_c = 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 r_c and a municipal bond yielding r_m 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.