Introduction
Investing in bonds is common among risk-averse investors seeking to mitigate risks on principal amount and income. However, selecting the optimal bond mix is challenging, given the impact of taxes on bonds. This essay will explore the concept of taxable equivalent yield and compare the DES Corporate Bond with the FDR Municipal Bond in terms of yield and risk. Accomplishing this will help Beth Anaheim understand why an FGR Bond investment has a higher yield and lower risks.
Main Body
It is essential to consider the concept of Taxable Equivalent Yield when evaluating taxable and tax-exempt bonds. Tax-exempt bonds, such as municipal bonds, offer income through regular interest payments that are not subject to federal income tax (Cebula & Clark, 2019). In some cases, municipal bonds are also exempt from state and local taxes (Drukker et al., 2020). Corporate bonds, on the other hand, are subject to taxation at the federal, state, and sometimes at the local level (Larcker & Watts, 2019). In this case, there are two bonds, the DES Corporate Bond and the FGR municipal bond.
The first one is A-rated, offers a 9% coupon rate, and matures in seven years. On the other hand, the FGR municipal bond is AAA-rated, has a seven percent coupon rate, and matures in seven years. At first glance, the DES bond may seem attractive to a potential investor because of its higher interest rate. However, for an investor such as Beth, who is at a 30 percent combined marginal tax rate, interest from this bond would be subject to taxation.
To understand the impact of the taxable on the bond’s yield, one should calculate the taxable equivalent yield on the FGR bond. The taxable equivalent yield is calculated using the following formula: Tax Exempt Yield/ (1-Marginal Tax Rate) = 7%/ (1-0.3) = 10% (Akan & Tevfik, 2021). Hence, the taxable-equivalent yield for the FGR municipal bond reaches 10%, which is higher than 9% offered by the DES corporate bond.
Risk is another crucial factor that should be considered when comparing bonds. In this case, the FGR municipal bond has the coveted AAA rating, indicating a significantly lower default risk (Omstedt, 2019). On the other hand, the DES corporate bond has a significantly higher default rate than the municipal bond due to its A rating. Consequently, the FGR municipal bonds are considerably less risky than the DES corporate bonds.
Conclusion
In conclusion, despite DES bonds offering a higher coupon rate, the FGR municipal bonds have a higher taxable equivalent yield is higher. Additionally, the FGR bonds are rated AAA compared to the A rating of the DES bonds, meaning there is a relatively lower risk of default for municipal bonds than corporate bonds. Therefore, the FGR municipal bonds offer Beth an opportunity to achieve a higher income at a relatively lower risk than the DES corporate bonds.
Thus, understanding the concept of taxable equivalent yield is necessary when comparing two types of bonds, especially when one bond is taxable while the other is tax-exempt. Understanding bond rating is also essential because it allows one to gauge the risk of default. When an investor’s objective is safety and current income, using the ratings and the taxable equivalent yield helps select bonds that will result in higher yields and lower risks.
References
Akan, M., & Tevfik, A. T. (2021). Fundamentals of Finance Investments, Corporate Finance, and Financial Institutions. De Gruyter.
Cebula, R. J., & Clark, J. R. (2019). The tax-rate induced bond substitution hypothesis and the traditional textbook treatment of the relationship between tax-free and taxable bond yields. Applied Economics, 52(14), 1606–1616. Web.
Drukker, A. J., Gayer, T., & Gold, A. K. (2020). Tax-exempt municipal bonds and the financing of professional sports stadiums. National Tax Journal, 73(1), 157–196. Web.
Larcker, D. F., & Watts, E. (2019). Where’s the greenium? SSRN Electronic Journal, 69(23). Web.
Omstedt, M. (2019). Reading risk: The practices, limits and politics of municipal bond rating. Environment and Planning A: Economy and Space, 52(3), 611–631. Web.