What it means
Local governments borrow by issuing bonds to pay for schools, roads, water systems and other public projects. In many countries, including the United States, interest on most of these bonds is exempt from national income tax, which lets governments borrow at lower rates.
The tax break is allowed only for approved public purposes. When a project falls outside those approved purposes, such as certain private-use facilities or the refinancing of older debt in some situations, the bond may have to be issued as taxable.
The government then pays a higher rate, because investors cannot enjoy the tax shield. Interest on the bond is taxed like interest from a company bond.
The investor base is different as well, and so is the pricing. Tax-exempt bonds suit people in high tax brackets, but taxable municipal bonds also appeal to buyers that gain nothing from tax exemption, such as pension funds, insurers, charities and foreign investors.
These buyers can accept a higher yield without losing a benefit they could never use. Taxable municipal bonds sit between government bonds and corporate bonds in risk.
They are backed either by the issuer's general taxing power or by revenue from a specific project, such as a toll road or a water utility. Credit quality varies, and investors rely on credit ratings and the issuer's financial statements to judge it.
The yield comparison is the practical heart of the matter. To compare a taxable bond with a tax-exempt one, an investor converts the tax-exempt yield into its taxable equivalent or converts the taxable yield into an after-tax figure.
Which is better depends on the investor's personal tax rate. Because tax rules differ between countries, and sometimes between regions, the exact treatment must be checked locally.
The general lesson is that the same type of issuer can offer very different after-tax returns depending on how the bond is classified.
In practice
Real-world examples.
Example
A city issues bonds to build a stadium that will be used mainly by a private team. Because the project does not qualify for tax relief, the city sells the bonds as taxable and offers a higher interest rate to attract investors.
Example
A university endowment fund, which pays no tax on its income, buys taxable municipal bonds yielding 5%. It prefers them to tax-exempt bonds yielding 3.6%, because it gains nothing from the exemption.
Example
An insurance company needs steady income to match its long-term obligations. Its investment team buys a taxable bond from a state water authority because the yield is attractive and the issuer's revenue is stable.
Formula
Calculation
After-tax yield = Taxable yield x (1 - Tax rate)
Taxable-equivalent yield = Tax-exempt yield / (1 - Tax rate)
An investor in the 28% tax bracket is offered a taxable municipal bond yielding 5% and a tax-exempt bond yielding 3.6%. After-tax yield on the taxable bond = 5% x (1 - 0.28) = 5% x 0.72 = 3.6%. Taxable-equivalent yield of the tax-exempt bond = 3.6% / 0.72 = 5.0%. On a $100,000 investment the taxable bond pays $5,000 of interest, tax of 5,000 x 0.28 = $1,400, and leaves $3,600 after tax, exactly the same as the tax-exempt bond, so the investor is indifferent.Case study
Seen in the real world.
Bayview County is an illustrative, fictional local government that wanted to refinance $60,000,000 of older debt. Its advisers told the finance committee that the refinancing would not qualify for tax-exempt treatment, so the new bonds would have to be taxable.
The finance officer compared two options. Tax-exempt bonds were not available, and taxable bonds would cost 1.4 percentage points more in annual interest than the county had hoped.
The county still went ahead, because the new interest rate was lower than that on the old debt. In this illustrative story, the finance committee published the analysis so residents could see the saving, which came to roughly $450,000 a year after all costs. The committee also noted that investors in the new bonds would pay tax on their interest, which is why the rate on offer was higher than on the county's earlier tax-exempt issues.
Watch out
Common mistakes.
- Assuming all municipal bonds are tax-free, when some are issued as taxable because of what the money is used for.
- Comparing yields without adjusting for tax, which can make a tax-exempt bond look worse than it really is for a high earner.
- Treating every municipal bond as risk free, when issuers can face financial trouble and credit quality varies.
Questions
People also ask.
Who buys taxable municipal bonds?
Mainly investors who cannot use a tax exemption, such as pension funds, insurers, charities and overseas buyers.
Why do taxable municipal bonds pay more than tax-exempt ones?
The issuer must compensate investors for paying tax on the interest, so the higher rate attracts buyers.
Are taxable municipal bonds safer than corporate bonds?
Not automatically, because safety depends on the issuer's finances and the source of repayment, not just the label.
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