For those unfamiliar, stocks (equity securities) represent ownership of the issuing corporation. Bonds however represent loans to the issuer. Since municipalities (local governments) can’t be purchased, they typically issue bonds (municipal bonds) to raise money for various reasons.
Most Municipal bonds have lower yields than most other bonds. The nominal yield takes into consideration the purchase price, the number of years until the bond matures, and the interest rate. Typically, bonds that are considered safer have lower interest rates than riskier bonds. You may think that because U.S. government securities (T-bills, T-notes, T-bonds, and so on) are the safest of all securities, they should have the lowest yields. Not so, because municipal bonds have a tax advantage that U.S. government bonds don’t have: The interest received on municipal bonds, with a few exceptions (i.e., tax credit Build America Bonds, tax credit Build America Bonds) is free from federal taxes.
How Do We Compare Municipal Bonds and Corporate Bonds Equally?
Because the interest received on most municipal bonds is federally tax-free but the interest received on corporate bonds is federally taxable, we have to have a formula for comparing the bonds equally. The typical formula used is the Taxable Equivalent Yield (TEY) formula.
For simplicity’s sake, let’s assume that we are comparing a 20-yr municipal general obligation bond with a 3% coupon (interest) rate with a 20-yr corporate bond with a 3.5% coupon. For our purposes, we’ll say that both bonds were purchased at par value (not at a premium or discount). Now, assuming the investor’s tax bracket is 22%, the formula would look like this:
TEY = municipal yield / 100% – investor’s tax bracket
TEY = 3% / 100% – 22% = 3% / 78% = 3.85%
For this investor, purchasing a 3% municipal bond is equivalent to purchasing a 3.85% taxable bond. Looking at the previous paragraph, this investor (assuming all things like ratings and years till maturity) would be better off purchasing the 3% municipal bond over the 3.5% corporate bond because the after-tax yield would be higher.