Principles of Finance: Unit 5, Comparing Muni Bond Returns with the Returns of Taxable Bonds

Here, we'll compare muni bond returns with the returns of taxable bonds. Hint: "tax-deductible" is a good thing. Unless you're the charitable sort.

CoursesFinance Concepts
Principles of Finance
FinanceFinancial Responsibility
Personal Finance
Finance and EconomicsPrinciples of Finance
LanguageEnglish Language
Life SkillsPersonal Finance
SubjectsFinance and Economics

Transcript

00:25

durations in munis well no not necessarily... [The questions are crossed out on a whiteboard]

00:28

All right hint as always the answer rhymes with shmaxes, yep muni bond

00:33

interest is tax deductable so if you pay say 50 percent marginal federal and

00:40

state income tax in a blue state muni bonds could pay a lot less interest than [The lights are turned off for the presentation]

00:45

their similar risk taxable corporate bonds and you'd still be better off. That

00:50

is if a corporate bond pays nine percent interest which is to you four and a half

00:55

percent after tax and doubly deductible muni bonds pay five percent meaning [The different bonds and their tax rates are shown on a whiteboard]

00:59

deductible from state and federal well you do better on a net after-tax basis

01:04

everything else held equal with the muni bond than you would on the corporate

01:08

bond. There's one formula that you need to know that applies here and it'll save

01:12

you hours of grief and gallons of blood shed if you just memorize it. The catchy [Woman looking depressed]

01:17

title, the tax equivalence of taxable and tax-free bonds it was the original title

01:23

of Moby Dick I think yeah well maybe not... All right well the formula is as follows [Whale pops up and says no one is going to read that]

01:27

tax-free interest rate divided by the quantity one minus the tax bracket.

01:33

All right, let's make up an example here where the tax equivalent rate is 3% that is you're

01:37

paying 50 percent tax on a corporate bond that yields six percent well how's

01:41

that work? Well the tax-free interest rate is three percent meaning that a

01:46

doubly tax-free muni bond pays three percent and you're dividing it by one

01:51

minus your tax bracket or rather the marginal tax you pay on the last dollar [The working are shown on the whiteboard]

01:56

you earn. If that rate is 50 percent well then the break-even price is 1 minus 0.5

02:01

there which is in California anyway 0.5 and that number gets divided into the 3

02:06

percent to equal 6 percent. All right we showed you all the math there

02:10

get it got it good because don't worry Uncle Sam always get his. [Get it, got it, good, pops up quickly]

02:14

I want you to pay taxes...