As we've seen, investors can manage the risks of bond investing by incorporating high-quality securities laddered over several maturities. But there's another important factor to consider when investing in bonds: taxes.
Too often fixed income investors take a homogenous approach to their bond investment selections. They frequently build portfolios consisting entirely of tax-free municipal bonds or exclusively of taxable corporate bonds. For many investors in higher tax brackets, a portfolio structured wholly using tax-free municipal bonds can be the best method, since the highest tax bracket is now 39.6 percent (plus other taxes, such as state taxes and the new 3.8 percent net investment income tax that took effect in 2013). However, some investors may benefit from a combination of taxable and tax-free securities to boost their expected after-tax returns, provide additional liquidity, and increase overall after-tax cash flow. Let's take a look at a few examples.
When constructing bond ladders, we consider short-term bonds as those maturing within one to four years. Bonds within this maturity range can defend against a potential rise in interest rates or provide liquidity for any unforeseen cash needs. Given the current environment of depressed interest rates, it may make sense for investors to use short-term corporate bonds to produce a higher after-tax return. In the following example, we approximate the value of this tactic by comparing the yield to maturity of a corporate bond to a municipal bond's tax-equivalent yield, which factors tax savings into the expected return.
Tax-equivalent yields are calculated by dividing the municipal bond yield to maturity over one minus the tax rate:
Let's compare the short-term bonds in the table below.
For this example, and using a 33 percent average total tax rate, our calculation would be:
The tax-equivalent yield is 0.70 percent, compared to the 2.03 percent yield of the corporate bond. In this example, using the corporate bond's 2.03 percent yield clearly provides a higher after-tax yield.
In addition to generally providing a higher after-tax return—and despite often being of lower credit quality—short-term corporate bonds tend to be more liquid than municipal bonds. Generally, it's easier to find buyers that will pay closer to fair value for a corporate bond than they would for a municipal bond, because municipal bonds tend to come in smaller issue sizes and are less frequently traded. If cash needs require a bond to be sold prior to its maturity date, short-maturity corporate bonds are less likely to be sold at a significant discount than municipal bonds.
Let's review another tax-equivalent yield example, this time with a longer maturity:
Using the same 33 percent average total tax rate, our calculation would be:
In this example the municipal bond provides a tax equivalent yield of 2.21 percent, which is significantly lower than the pretax yield of the corporate bond. These examples above may raise the question: Why not build a portfolio solely of corporate bonds and exclude tax-free municipals altogether?
First, the examples above pertain to the current interest rate environment, and there are times when municipal bonds provide a higher tax equivalent yield. But more important, municipal bonds default at a much lower rate than corporate bonds, which makes them better suited for a preservation of capital mandate. Using lower-quality corporate bonds for the entire portfolio would decrease the overall credit quality and subject the portfolio to higher price volatility and a higher rate of default risk. The lower credit ratings of these corporate bonds are another reason we recommend including them in the shorter maturities rather than the longer maturities, given the lower risk of default in a shorter time frame.
It's also important to consider your overall tax situation. Constructing a portfolio solely of taxable bonds may increase your taxable income to a point where you're pushed into a higher tax bracket. The added income could also have other impacts—such as causing additional Social Security benefits to become taxable or forcing some deductions to be phased out—which would essentially result in further increases to your average tax rate. While each situation is different, we often find that an allocation of 15 to 25 percent corporate bonds is appropriate.
The examples above use BB–BBB rated corporate bonds, since we find these lower-rated corporate notes more attractive in the short term. But we can also compare the broad market of higher-quality AA rated corporate notes versus municipal bond tax equivalent yields at a 33 percent average total tax rate. In this case corporate notes continue to provide a better yield in the shorter maturities, and municipal bonds provide a better tax equivalent yield in the longer maturities.
Additionally, we like to purchase municipal bonds in the longer term maturities because they add stability to a portfolio. Even in portfolios where taxes are not a concern, such as retirement accounts, we'll often purchase taxable municipal bonds rather than corporate bonds in the longer maturities. This is because, historically, municipal bonds have generally had lower price volatility and experienced fewer defaults than comparable corporate bonds. According to Moody's (as of the end of 2012), 10 years after being rated A, municipal bonds had a 0.05 percent default rate versus a 2.5 percent default rate for corporate bonds.
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In the current market, with its historically low interest rates, every additional amount of yield is important. Work closely with your Moss Adams Wealth Advisor and your CPA or tax professional to learn whether these market-driven strategies are a good fit for your fixed income portfolio and implement them correctly.
creates custom fixed income strategies for individuals and corporate clients and leads much of the due diligence, analysis, and monitoring of the funds and individual securities included in client portfolios. You can reach her at (503) 478-2295 or
has over 28 years of experience in financial services. He leads the firm’s fixed income technical discipline group and designs and implements custom fixed income portfolios for individual and corporate clients. You can reach him at (206) 302-6718 or