Coupon earnings on municipal
bonds are free of
federal income tax. For residents of the state where issued, they
are also free of state income tax. One would expect with their
status that the yield-to-maturity (YTM) on muni bonds is a proper
measure of the after-tax
return. But this is not the case.
YTM is computed on the assumption
that all coupon
earnings are reinvested at the YTM rate. In practice this is not
possible. Usually the earnings are held in a short-term
like a money market fund. We assume here that they accumulate at
compound interest in a taxable fund, paying 2.5% per annum.
Because of their tax-free status,
muni bonds normally
offer lower YTMs than do taxable bonds. Their main benefits come
into play only for those in the higher tax brackets. We therefore
assume a relatively high combined state and federal tax rate of 40% on
ordinary income, and 24% on capital gains.
A muni purchased at a discount has
a capital gain
at maturity that is subject to tax. On the other hand, a muni
at a premium suffers a capital loss at maturity, but
that loss is exactly compensated by the higher coupon earnings, and
cannot be claimed as a capital loss for tax purposes.
We will examine three muni bonds,
each with a
YTM of 4%, and maturity of 5 years. They differ only in the
rates which are 6%, 4%, and 2.5%, respectively. The first sells
a premium, the second at par, and the third at a discount. Even
they have the same YTM, their after-tax returns will differ.
In computing the return on each of
the muni bonds,
we first determine the value of the investment at maturity. This
comprises the face value of the bonds, plus the tax-free coupon
plus the after-tax compound interest earned on the reinvested coupons,
minus the capital gains tax on discounted bonds. The five-year
relative to the purchase price is then converted into an equivalent
return. This can also be converted into a bond equivalent yield
comparison against the quoted yield-to-maturity. The results are
shown in the table.
** For 5 years to maturity
Note that the 4% coupon bond
has a bond-equivalent
yield less than the 4.0% one would expect for a bond sold at par.
This is because the after-tax return on the reinvested coupons is below
the YTM rate.
Also note that the 4% coupon
has a better return
than either the 6% coupon or the 2.5% coupon. The 2.5% coupon
mainly from the capital gains tax bite. The 6% coupon suffers
a higher fraction of the total return comes from the interest on the
coupons which are taxed as ordinary income at the combined state and
capital loss on
the 6% coupon were tax-deductible, the bond-equivalent yield would be
which is above the YTM on a fully tax-free bond bought at par.
would represent a tax loophole favoring high coupons sold at a
and explains why such a tax loss on a "tax-free" muni bond is
Two lessons can be learned from
(1) The return on a muni is
tax-free. The effective yield is normally less than the YTM
at time of purchase, even for those bought at par.
(2) For a given YTM, munis
bought at either
a large premium or discount return less than those bought at or near