7.692=5.00 “The Sequel”

Referring to my last post, think about the significance of this difference of 2.692 per cent.  (We’ll call it the taxable equivalent spread.)   I mentioned that the TEY or taxable equivalent yield (it’s time for you to get used to the language used in the investment world!) of a municipal bond is the proper metric to compare to yield of a taxable bond.  Let’s consider how that extra yield works in your favor with the power of compounding.

Original Investment $25,000
Coupon on the Bond 5%
Annual Payment (made every 6 months) $1250
Yield on the Bond until Maturity (YTM) 5%
Tax Bracket 35%
TEY 7.692%

If an investor can continue to reinvest the coupon payments at 5% on the $1250 annual payment over the next 10 years while not paying taxes…

Coupons = 1250 x 10 = 12,500
Interest on Coupons 3,465.41 <– by the way, this is not difficult nor “spooky” math.  just think of receiving payment 1 in month 1 and then the adding the accumulated interest you’d earn from then until you receive the next payment.

And 5 years after that…(still while not paying taxes)…
Coupons = 1250 x 15 = 18,750
Interest on Coupons 8,689.19

And 5 years after that (might as well, this is fun, right?)…
Coupons = 1250 x 20 = 25,000
Interest on Coupons 17,126.60

So assess what has happened after the 20 year investment period:

  1. the investor has recouped his or her original investment.  Remember in my last article that one of the more important concerns of investors is the protection of principal;
  2. if not spent, the investor has had a reasonable amount of cashflow produced although they chose to reinvest the coupons;
  3. Better yet, this investment has been done without Uncle Sam taking a portion of it because all of the interest from the bond has been tax-free.

A taxable bond would have had the same math but at the 35% tax bracket (see above), your incremental compounding would have differed by the following:

after 10 years…
Coupons = 1250 x 10 x (1-.35) = 8,125
Interest on Coupons = 2,252.52

And 5 years after that…(while now paying taxes)…
Coupons = 1250 x 15 x (1-.35) = 12,187.50                              Interest on Coupons = 5,647.97

And 5 years after that…
Coupons = 1250 x 20 x (1-.35) = 16,250                                        Interest on Coupons = 11,132.29

That is a difference of 14,744.31 or 35%–coincidentally your tax bracket!  So the lesson here is that the higher your bracket (which is directly related to your annual earnings), the more diligent you should be in including tax-efficient investing strategies into your investment plan.  A trustworthy, reputable investment professional that has access to structured bond ladders can take advantage of this concept for you, while also managing your interest rate risk.
I also haven’t mentioned the bond has not been called or matured yet either.  So unless the issuer defaults on the principal or interest payments, the investor will still get back the original $25,000 investment!  Let’s say that the bond matured in 20 years like the example above.  That would be a total return of $67,126.60 or 168.5%!

7.692=5.00

The above is either some real funky math or I need to take a visit to Khan Academy–or both!

Regardless of what you’re hearing from the headlines (and talking heads) that encourage fear and being afraid to invest in the market, there is an asset class that has done pretty well despite the cognitive resistance.

What asset class?  Muni bonds.

Municipal bonds have performed well when considering what a reasonable investor might expect from an investment:

  • outpace inflation with some capital appreciation,
  • provide current cashflow,  and
  • provide a decent probability of return of the original investment.

Let’s explore each of these 3 points while explaining my math from above.

Outpace Inflation…

After speaking with hundreds of investors over my years in financial services one common concern is the erosion of purchasing power over their investment horizon.  Thus it is necessary to find suitable investments that not only fit a particular risk tolerance but also exceed the rate of inflation.  Municipal bonds fit these criteria even using a very high historical CPI number like 3%.  Although municipal bonds can pay lower than 3%, bonds with maturities of 10 years and longer typically pay more.

Provide Cash Flow…

Cash is king!  Let’s look at an example…

  • Original Investment = $25,000
  • Bond’s interest rate (e.g. coupon) = 5%
  • Bond’s yield at purchase = 5%
  • Annual Cash Payment = $1, 250
  • Tax Rate = 35%

If this bond pays tax-free income, the investor would receive more than the 5% return on their money every year.  How?  Since the cash payments are exempt from federal income tax, the taxable equivalent yield (or TEY) needs to be calculated, which is:

.05 /  (1-.35) = .07692 or 7.692%

So the municipal bond investment yields 7.692% when considering the 35% tax bracket. At this writing the 30 year US treasury bond yields just 3.137%–less than half of the tax free municipal bond! Need I say more?

Provide a Decent Probability Principal Return…

Without going into too much detail of statistics and standard deviation, I can tell you that there is a lot of research evidencing less than a 0.5% default rate for investment grade municipal bonds for the last few decades.  (For you quants, here is a study that you’ll like.) Which means that of all the bonds issued that are investment grade, there is about a 1/2 percent chance that you lose your original investment.  Even in cases where bankruptcy is involved (e.g. Detroit), there was recovery value of greater than 60% for some holders of the debt.

Needless to say, your choice of bonds or bond funds should be done after the following steps are taken with a qualified professional:

  1. review of your investment goals and objectives including risk tolerance;
  2. full design of an investment plan;
  3. thorough analysis of investment choices

Further Food for Thought:

www.investopedia.com

www.investinginbonds.com

The Bond Book (3rd ed.)