Simplifying After-Tax and Tax-Equivalent Yields

For many when choosing bonds the most important factor is the tax implications. Knowing the after-tax yield and tax-equivalent yield calculations is critical. Continue reading

Bonds can be nice, reliable investments. Pay some money to an issuing company or municipality, receive interest payments twice a year, and then get all of your original investment back sometime down the road. Sounds like a plan.

But which bonds are best for a specific investor? There are many factors for bond investors to consider when choosing which bond to buy, but for many the most important is the tax implications of investing in one bond instead of another. This concern is most prominent when an investor compares a corporate bond to a municipal bond. For reference, a corporate bond is one issued by a corporation or business, while a municipal bond is one issued by a state, city, or municipal agency.

Comparing the tax implications of these bonds is important because the interest payments that investors receive from municipal bonds are typically not taxed at the federal level. Conversely, interest payments on all corporate bonds are subject to federal taxation. This means that someone in the 32% tax bracket will have to give Uncle Sam 32% of his interest received from a corporate bond, while he will not give up any of his interest received from a municipal bond. Additionally, an investor does not pay state taxes on municipal bond interest if the bond is issued in the state in which the investor lives. Corporate bond interest, on the other hand, is always subject to state tax.

  • interest payments taxed federally
  • interest payments subject to state tax
  • interest payments not federally taxed
  • interest payments not taxed by state if issued in state local to investor

For these reasons, when comparing a corporate bond to a municipal bond, understanding the after-tax yield and the tax-equivalent or corporate-equivalent yield is essential. This is true both for investors and for those who will be taking many of the FINRA, NASAA, and MSRB exams. So let’s look at how to calculate those yields.

After-Tax Yield

First the after-tax yield. The after-tax yield tells you the amount of a corporate bond’s annual interest payment that an investor will take home after accounting for taxes he will be assessed on that interest. Once that amount is known, the investor can compare it to the yield he would receive from a specific municipal bond and see which potential investment would put more money in his pocket. When calculating the after-tax yield, start with the annual interest percentage (a.k.a. coupon percentage) of the corporate bond, which represents the percent of the bond’s par value that an investor receives each year in interest. For instance, a corporate bond that has a $1,000 par value and an interest rate of 8% will pay an investor $80 dollars in annual interest ($1,000 x 0.08 = $80). You then multiply the coupon percentage by 1 minus the taxes an investor will pay on the corporate bond that he will not pay on the municipal bond that he is considering.

This is where it sometimes gets tricky. What taxes will an investor not pay when investing in a municipal bond that he will pay when investing in a corporate bond? Remember that for just about all municipal bonds, investors do not pay federal tax on interest received.

The formula for after tax yield is:

After-tax yield = Corporate Bond Annual Interest Rate x
( 1 – Taxes Investor Does Not Pay By Investing in Municipal Bond)

On the other hand, an investor always pays federal taxes on interest received from a corporate bond. Additionally, an investor does not pay state taxes on interest payments from a municipal bond issued in the state in which the investor lives.

On the other hand, an investor always pays state taxes on interest received from corporate bonds. So if you see an exam question in which you need to calculate the after-tax yield of a corporate bond to compare it the yield on a municipal bond, you will always subtract the investor’s federal income tax rate from 1 in the equation. You will also subtract the investor’s state tax rate from 1 if the municipal bond is issued in the investor’s state of residence.

Seems simple, right? Here’s a question to provide context:

Marilyn is a resident of Kentucky. She is considering a bond issued by XYZ Corporation. The bond comes with a 7% annual interest rate. Marilyn is also interested in purchasing municipal bonds issued in Ohio. If Marilyn has a federal tax rate of 28% and Kentucky’s state tax rate is 4%, what is the after-tax yield on XYZ’s bond?

To answer this question, begin with the interest rate on the XYZ bond, which is 7%. Then subtract from 1 the taxes Marilyn will not pay if she invests in the municipal bond in question. She will not pay federal taxes on the municipal bond interest, so you would subtract 28%, or .28. However, because Marilyn is a resident of Kentucky and the municipal bonds she is considering are issued in Ohio, she will pay state taxes on the bond. That means you would not subtract her state tax rate (0.04) from 1. After subtracting .28 from 1 to get 0.72, you multiply that amount by the 7% coupon payment. Doing so gives you a value of 5.04 (7 x 0.72 = 5.04%). This means that the interest amount she would take home from the XYZ bond would be equivalent to what she would receive from a municipal bond issued in Ohio that has a 5.04% interest payment. If she can get a bond issued in Ohio that has a higher interest payment than 5.04%, she would take home more money in annual interest payments than she would from the XYZ bond.

Tax-Equivalent Yield

The second approach an investor can take to compare how a potential bond investment will be affected by taxation is to calculate the tax-equivalent yield (TEY). This calculation is also known as the corporate-equivalent yield (CEY). The TEY/CEY measures the yield that a corporate bond will have to pay to be equivalent to a given municipal bond after accounting for taxes due. To calculate this yield, you take the annual interest of the given municipal bond and divide it by 1 minus the taxes the investor will not pay if she invests in the municipal bond that she would pay if she invested in a corporate bond.

Here’s the formula for tax-equivalent yield:

Tax-equivalent yield = Municipal Bond Annual Interest Rate /
(1 – Taxes Investor Does Not Pay By Investing in Municipal Bond)

When determining what tax rates to subtract from 1 in the denominator, the same principal as described above applies. That is, the investor will not have to pay federal tax on the municipal bond, so her federal rate is always subtracted from 1. The investor will also not have to pay state tax on the bond if it is issued in the state in which she lives. If that is the case, the investor’s state tax rate should also be subtracted from 1. However, if the investor lives in a different state than the state in which the bond is issued, she will have to pay state taxes on the interest payments. In that case, her state tax rate would not be subtracted from 1.

Here’s another question to provide context.

Franz, a resident of Michigan, has purchased a Michigan municipal bond that pays 4% annual interest. If his federal tax bracket is 30% and the Michigan state tax rate is 4%, what interest rate would he need to receive on a corporate bond to have a comparable rate after accounting for taxes owed?

To answer this question, begin with the interest rate on the Michigan municipal bond, which is 4%. Then subtract from 1 the taxes that Franz will not pay on that bond that he would pay if he invested in a corporate bond. He wouldn’t pay federal taxes on the municipal bond interest, so you would subtract 0.30 from 1. Additionally, since the bond is issued in Michigan and he is a Michigan resident, Franz will not pay state taxes on the bond. So you subtract Michigan’s state tax rate of 4%, or 0.04, from 1 as well. After subtracting 0.30 and 0.04 from 1 to get 0.66, you divide that number into the 4% municipal bond annual interest. Doing so gives a value of 6.06 (4 / 0.66 = 6.06). This means Franz would need to find a corporate bond that pays 6.06% in annual interest to match the amount of interest he will take home annually from the Michigan municipal bond after accounting for taxes.

Many people are confused by the concepts of the after-tax and tax-equivalent yields. But you don’t have to be one of them. Just follow this simple approach and any questions you see on this topic will not be overly taxing.

Mastering these equations will help you succeed in passing the Series 6, Series 7, Series 50, Series 52, Series 65, Series 66, and Series 82.

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Broker-Dealer vs. Investment Adviser: What’s the Difference?

Do your customers know the difference between an IA and BD? Do you know the importance of this distinction and how it may affect your registration status? Continue reading

Do your customers know the difference between an investment adviser and broker-dealer? Do you know the importance of this distinction and how it may affect your registration status? 

Investment Adviser or Broker-Dealer at work.

For many retail customers, the difference between an investment adviser (IA) and a broker-dealer (BD) may not seem important. A customer may have received an investment recommendation from a BD, or owned securities through an IA account. However, which kind of firm you work for is important for knowing which services you may provide, how you may provide them, and which qualification exams you must pass.

Investment Advisers

Investment advisers are usually firms, though they can be an individual operating as a sole proprietor, whose primary business is providing investment advice, and who are paid for the advice itself. Investment adviser representatives (IARs) are individuals who work for IAs and advise the IA’s clients on the IA’s behalf. IAs and IARs are not “stockbrokers” and cannot directly buy or sell securities for their customers. While many have IA accounts through which they own stocks, mutual funds, and other securities, in fact these are accounts an IA opens on the customer’s behalf with a BD. 

Broker-Dealers

Broker-dealers are usually firms, though they can be an individual operating as a sole proprietor, that execute securities transactions for customers. An individual who is employed by a BD to handle customer accounts is called an “agent of a broker-dealer” on some exams, or a “registered representative” (RR) on others. BDs can offer investment advice incidental to their work with customers but cannot be compensated for the advice itself. If a BD acts as an intermediary between a buyer and a seller, then the BD can charge a commission on the trade. If a BDs buys or sells from its own inventory, then the BD makes money by charging a markup on securities that they sell and taking a markdown on securities that they buy.

So, if you’re an IAR, you… 
  • …can provide advice
  • …can be paid for that advice
  • …cannot execute trades
  • …cannot charge commissions or markups on your customer’s trades
If you’re a BD agent (also known as a registered representative), you…
  • …can provide advice
  • …cannot be paid for that advice
  • …can execute trades
  • …can charge commissions or markups on your customer’s trades

Testing and Licensing

Finally, many firms, especially larger ones, maintain both IA and BD registrations. When working for these “dual registrants,” you may be asked to qualify as an IAR, BD agent, or both, depending on your role.

In fact, an increase in dual registrations is one of the note-worthy trends Solomon discusses in our recent white paper, “Optimizing On-Boarding in 2021: 7 Key Trends for the Securities Industry,” available for download from this blog post

To become an agent of a broker-dealer (registered representative), you must pass the Securities Industry Essentials (SIE), and a “top-off” exam such as the Series 6 or Series 7, and for state registration usually the Series 63. To become an IAR, you must pass either the Series 65, or, if you work for a dually registered firm, the SIE, the Series 7, and the Series 66.

January Study Question of the Month

This month’s study question from the Solomon Online Exam Simulator question database is now available. Continue reading

This month’s study question from the Solomon Online Exam Simulator question database is now available.

***Comment below or submit your answer to info@solomonexamprep.com to be entered to win a $20 Starbucks gift card.***

This question is relevant to the SIE, Series 6, 7, 22, 24, and 82 exams.

Question:

Which of the following people would be considered a specified adult?

Answer Choices:

A. A 16 year old with autism

B. A 30 year old

C. A 60 year old with a heart condition

D. An 18 year old in a coma

Correct Answer: D

Explanation: A specified adult is a natural person age 65 and older or a natural person age 18 and older who the member firm reasonably believes has a mental or physical impairment that renders the individual unable to protect his or her own interests.

December Study Question of the Month

This month’s study question from the Solomon Online Exam Simulator question database is now available. Continue reading

This month’s study question from the Solomon Online Exam Simulator question database is now available.

***Comment below or submit your answer to info@solomonexamprep.com to be entered to win a $20 Starbucks gift card.***

This question is relevant to the Series 6, 7, 14 and 79 exams.

Question: 
 
Which of the following is not typically part of an underwriting agreement?
 
Answer Choices:
 
A. Description of the per-share underwriting spread
 
B. Description of a Greenshoe option
 
C. Terms between syndicate members and selling group dealers
 
D. Terms under which the underwriter can terminate the contract
 
 

Correct Answer: C

Explanation: The underwriting agreement, which is typically signed the evening before or the morning of the effective date of a securities issue typically includes the per-share underwriting spread, an over-allotment (Greenshoe) option if granted, and the underwriter’s termination rights. It also is the document that contains the public offering price or a formula to derive it.

 

SEC Announces Major Revisions to Registration Exemptions Aimed at “Harmonizing” Regulation A Offerings, Regulation D Private Placements, and Crowdfunding

On November 2, the SEC announced a collection of rule changes meant to, in the announcement’s words, “harmonize, simplify, and improve” its “overly complex exempt offering framework.” Continue reading

On November 2, the SEC announced a collection of rule changes meant to, in the announcement’s words, “harmonize, simplify, and improve” its “overly complex exempt offering framework.” The changes affect Regulation A, which governs small public offerings; Regulation D, which governs private placements; and Regulation CF, which governs crowdfunding. This system of exemptions allows various small offerings to avoid the normal registration process required by the Securities Act.  
 
The rule changes should provide a clearer choice as to which exemption is most appropriate to an issuer, based on how much the issuer needs to raise and other factors.
 
The changes also seek to clarify how issuers can avoid “integration” of exempt offerings. Integration is the risk that exempt offerings will be considered a single offering by the SEC, because the offerings are too similar.
 
Highlights of the changes include:
 
  • If two exempt offerings are conducted more than 30 days apart, they are almost always protected from integration.
  • An issuer can “test the waters” with potential investors before deciding which exemption it will use for an offering. Test-the-waters communications solicit interest in a potential offering before the issuer has filed anything with the SEC. Previously, an issuer could only test the waters after deciding that its potential offering would take place under Regulation A.
  • Caps on the amount that may be raised through these exemptions have been increased:
    • Crowdfunding: from $1.07 million to $5 million
    • Regulation A, Tier 2: from $50 million to $75 million 
    • Regulation D, Rule 504: from $5 million to $10 million
  • Make “bad actor” exclusions more consistent across different exemptions.
The rule changes will take effect early next year. Until the changes take effect, securities exam questions will continue to be based on the old rules. FINRA Exams affected by these rule changes include the SIE, Series 6, Series 7, Series 14, Series 22, Series 24, Series 65, Series 66, Series 79, and Series 82.

If you have ADHD and you are studying for the SIE exam or the Series 7 or the Series 65 … Solomon Exam Prep can help

It’s no small feat to study for and pass a securities licensing exam, especially if you have ADHD. With that in mind, Solomon has compiled a list of skill-based strategies to support ADHD learners through the process of studying for their securities licensing exams. Continue reading

Studying for a knowledge test, like a securities licensing exam, requires significant effort over time. Solomon offers some helpful tips for studying and passing your securities licensing exam(s).

Study Strategies for People with ADHD

It’s no small feat to study for and pass a securities licensing exam, especially if you have ADHD. Two areas that can be especially challenging for people with ADHD are time management skills and study skills. Time management can be difficult because it requires a person to prioritize tasks, organize their day, and plan for short- and long-term goals, all of which are potential stumbling blocks for those with ADHD. And when it comes to studying, people with ADHD often have trouble concentrating and haven’t acquired effective study habits.

However, studies suggest that people can learn specific behaviors and strategies that help them work around ADHD symptoms and succeed in their studies. With that in mind, Solomon has compiled a list of skill-based strategies to support ADHD learners through the process of studying for their securities licensing exams.

Time Management

If you’re planning to study for a securities licensing exam, such as the Securities Industry Essentials exam or the Series 7 or the Series 65, managing your time effectively is crucial. Depending on the exam, Solomon Exam Prep recommends studying for between 30 to 100 hours over the course of ten days to several weeks. It’s a daunting prospect for anyone. How can someone with ADHD get better at managing his or her time?

Use schedules and planners to stay on track. Whether you use a paper or digital planner, the following tips will help you use it to your advantage:

  • Refer to the Solomon Exam Prep study schedules located in the resources folder of your online Solomon account to help create an effective study plan.
  • Fill in your planner with study targets for each week and smaller goals for each day. People with ADHD often get overwhelmed when confronted with a large task, so breaking the task up into smaller pieces will make it more approachable.
  • Be realistic about how long things take for you and build in some breathing room for when things takes longer than expected. Also build in time for frequent short study breaks.
  • Begin the day by checking your planner to see which activities you need to do. Try to complete each day’s to-do list, but don’t panic if you don’t finish everything – you built in extra time, remember?

Build structure into your day with consistent routines and rituals.

  • Figure out your best time for study. Are you more alert in the morning, afternoon, or evening? Try to study at your optimal time as much as possible.
  • Use alarm clocks, timers, and alerts to help you structure your time, build routine, and remind yourself of important tasks. This article has some great tips on how to use your smartphone to stay organized.
  • Give yourself small rewards as you study and complete tasks. This article recommends people with ADHD improve their focus by routinely rewarding themselves for achieving small goals. A reward can be as simple as taking a 10–15 minute break to have a snack or take a walk around the block, which also helps prevent fatigue and loss of concentration.
Study Skills

Studying for a securities licensing exam can make you feel like you’ve landed back in high school or college, when you were forced to study and retain large amounts of information with the end goal of passing a test. If you were a successful student, the strategies that worked for you then will probably work for you now. But individuals without prior academic success, and those with ADHD, can increase the effectiveness of their study time by applying the strategies that follow.

Make note-taking a core aspect of your studying. Studies suggest that becoming a better note-taker can increase concentration and help learners make better use of their time by learning actively rather than passively. Here are some specific ways to boost your studying with note-taking:

  • If you have a hardcopy of your Solomon Exam Prep Study Guide, then highlight, underline, and write notes and questions in the margins as you read. If you are reading your Study Guide online or listening to your Audiobook, take notes on paper using a note-taking system that works for you, such as the Cornell, outlining, or mapping method, all described here.
  • Use color-coding to organize your notes. Invest in colored pens, highlighters, and sticky notes and use them strategically.
  • Return to your notes frequently: review them several times; rewrite them; read them aloud; create possible test questions from them.

Do A LOT of self-testing. Studies have found that incorporating more self-testing, or retrieval practice, into a study routine can significantly improve retention of material, especially for people with ADHD. The Solomon Exam Prep study system has two features specifically designed for self-testing:

  • Solomon Exam Prep Online Exam Simulator: with a large question bank and tools that help you identify areas that require more study, the Solomon Exam Simulator is the perfect way to incorporate self-testing into your study time.
  • Solomon Exam Prep Digital Flashcards: interactive true/false and definitions flashcards that can be organized by chapter and customized to target the terms and concepts you need to study more.

Teach the content to someone else. To be well-prepared for a securities licensing exam, candidates must truly understand the content. What better way to check your understanding than to teach the content to another person? Becoming the teacher to a friend or family member is a highly effective learning technique. This list of study tips for learners with ADHD includes talking about the concepts aloud to yourself or others. Even if you don’t have a study buddy or captive family member to lecture to, imagine that you’re teaching a course on the material and write up a lesson plan. Deliver your lesson to an empty room if need be, but the act of trying to explain the material out loud is a great way to confirm which areas you have a strong command of and which you need to study further.

Pandemic Study Tip: Practice With a Mask

Since Prometric test centers now require test-takers to wear a mask when taking a securities exam Continue reading

Since Prometric test centers now require test-takers to wear a mask when taking a securities exam, Solomon Exam Prep recommends that individuals studying for a securities licensing exam — such as the SIE, the Series 7 or the Series 65 — take at least one practice exam at home wearing a mask. Solomon Exam Prep’s Exam Simulator offers quizzes and timed and untimed practice exams. Wearing a mask while using the Solomon Exam Simulator will better simulate the pandemic test center experience and help you prepare for your exam.

Solomon Exam Prep, a leader in FINRA, MSRB, NASAA and NFA securities licensing exams, has helped thousands pass the SIE and the Series 3, 6, 7, 14, 22, 24, 26, 27, 28, 50, 51, 52, 53, 54, 63, 65, 66, 79, 82 and 99.

August Study Question of the Month

Submit your answer to info@solomonexamprep.com to be entered to win a $10 Starbucks gift card. Continue reading

Submit your answer to info@solomonexamprep.com to be entered to win a $10 Starbucks gift card.

Question

Relevant to the Series 6Series 7, Series 24, Series 26Series 62, Series 79Series 82, and Series 99.

 

 

 

 

 

Which of these records about your customer Doug is your firm required to retain for five years?
 
A. Doug’s customer ledger
B. A SAR you filed on Doug
C. A complaint Doug filed about you

D. A confirmation of one of Doug’s trades

Answer: B. The general tier of recordkeeping is three years, six years, and lifetime, although there are some records with retention periods of four or five years. Additionally, the firm must keep most records easily accessible for the first two years.

Customer ledgers fall in the six-year tier, Suspicious Activity Reports (SARs) fall in the five-year tier, customer complaints fall in the four-year tier, and trade confirmations fall in the three-year tier.