4.10  Taxation of U.S. Treasuries and Municipal Securities

One reason why an investor may choose to purchase Treasury or municipal bonds is that her interest is taxed at a lower rate than corporate bonds. For Treasury bond interest, an investor pays federal taxes, but no state taxes, on earnings. For municipal bonds, the tax benefits can be even greater. Investors pay no federal taxes on earnings from municipal bonds and also pay no state or municipal taxes if they live in the state or municipality that issued the bond. For this reason, sometimes municipal bonds are called “triple tax-free bonds.”

Because interest on corporate bonds is taxed at an investor’s ordinary income rate, investors often want to be able to compare after-tax yields of government or municipal bonds to corporate bonds. There are two ways to do this.

The most straightforward way is to multiply the yield of each kind of bond by one minus the tax rate for the bond. 

The tax rate represents taxes the investor would pay if he invested in a corporate bond that he would not pay if he invested in a given municipal bond. For example, imagine an investor who has a federal tax rate of 27% and a state tax rate of 3%. The investor would like to compare a corporate bond with a 10% yield and a municipal bond issued by the state in which he lives, which has a yield of 7.5%. We can calculate the corporate bond’s after-tax yield by multiplying 10% x (1 – 0.30), which equals 7%. We can compare this after-tax yield directly to the yield of the municipal bond because the investor will not pay federal or state taxes on this municipal bond. In this case, we see that the municipal bond, with a tax-free 7.5% yield, beats the corporate bond’s after-tax yield of 7%.

after-tax yield on a corporate bond = coupon rate x (1