With the Halloween season and seemingly non-stop dramatic headlines, there is no shortage of things giving investors the jitters. One thing that should not scare investors right now is the attractive yield opportunities for those seeking income.

However, as investors consider the new world of attractive yields, I see the following mistakes made regarding what type of bonds should be used for taxable accounts:

1. No consideration of the impact of taxes on interest income and after-tax return.
2. Blind allegiance to 100% municipal bonds for all taxable accounts regardless of the investor’s tax rate and the differing yield opportunities available.

Many investors are drawn to municipal bonds because the interest income from these bonds is generally tax-free at the federal level. Investors hate paying taxes, and the idea of getting tax-free income often feels like they are putting one past the IRS.

But the question is: Is the trick better than the treat with tax-free income? Well, it depends.

Beware the tax bracket

Knowing one’s marginal tax rate is key in making informed decisions on evaluating taxable bonds vs. municipal bonds. The U.S. has a generally progressive tax code—the more you make, (generally) the more you pay in taxes. The exhibit below represents the tax rate for income to include taxable interest income. The table includes the impact of the 3.8% Net Investment Income Tax (NIIT) for modified adjusted gross income greater than $250,000. The table shows federal tax only.

Source:  IRS

Tax-Equivalent Yield:  Don’t be frightened of the math

Once you know the yields and applicable tax rates of the taxable and municipal bond offerings, the calculation to determine which type of bonds to use is relatively straightforward. The Tax-Equivalent Yield helps you compare yields on an apples-to-apples comparison.

Tax-Equivalent Yield:  Municipal Bond Yield / (1-Tax Rate)           

Consider this scenario for two couples with a Married Filing Jointly tax status: Couple #1 has taxable income of $150,000 and Couple #2 has $400,000. Their marginal tax rates are 22% and 35.8% respectively. (Again, federal tax only). The municipal bond they’re considering investing in is currently offering a 4% yield.

Couple #1 Tax-Equivalent Yield:    4% / (1-22.0%) = 5.1%
Couple #2 Tax-Equivalent Yield:    4%/ (1-35.8%) = 6.2%

If a comparable taxable bond yields 6%, you can see Couple #1 is likely better in the taxable bond while Couple #2 should consider the municipal bond with a 4% yield. (6.2% is higher than 6%).

The haunting reality: Municipal bonds are not for every investor

You can see one’s tax rate plays a huge impact on the math and the decision on what type of bond to consider. The higher the tax rate, the more compelling the Tax-Equivalent Yield. But there are times when taxable bonds still provide competitive yields vs. municipals – even in the presence of taxes. It is not a slam dunk.

The table below helps see the impact of the yield and tax rates.

TAX-EQUIVALENT YIELDS FOR MUNICIPAL BONDS AT DIFFERENT YIELDS AND TAX RATES

Source: IRS and Frontier Asset Management

Again, you can really see the impact of higher tax rates on Tax-Equivalent Yields.

Frontier’s approach – no tricks, only treats

For Frontier’s Tax-Managed Strategies, we typically include both municipal and taxable bonds together. Generally, you will see a higher allocation to municipal bonds, but we also include taxable bonds.

Part of including both is to diversify our sources of fixed income return. The investing adage “Don’t put too many eggs in one basket” applies. We love municipal bonds but will diversify accordingly.

Also, there are interest rate environments and periods where the yield on taxable bonds is very compelling – regardless of the tax impact. We generally look at total return – not just yield or income.  The total return of taxable bonds can be compelling vs. municipal bonds at different times as well.

If the Frontier investment approach was centered around the goal of simply having low taxable distributions, we would have 100% of our fixed-income exposure allocated to municipal bonds. However, Frontier is looking to manage risk first and maximize after-tax return next. This leads us to consider both municipal bonds and taxable bonds.

In conclusion

The allure of tax-free income from municipal bonds can be tempting but remember that the decision is not a one-size-fits-all. If you have any questions or seek further insights into how Frontier can help maximize after-tax returns, don’t hesitate to reach out. We’re here to help make well-informed decisions that turn potential investment tricks into treats. Happy Halloween!