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.
|Coupon on the Bond||5%|
|Annual Payment (made every 6 months)||$1250|
|Yield on the Bond until Maturity (YTM)||5%|
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:
- 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;
- if not spent, the investor has had a reasonable amount of cashflow produced although they chose to reinvest the coupons;
- 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%!