We've talked a little about the basics of bonds, and how they're essentially a loan that you give out to either the government or to a company. Bonds mature over time, and pay dividends while they're maturing. Then ou cash in mature bonds. There are a lot of different kinds of bonds, and figuring out the wisest investment for your situation can be daunting. Here's a comparison of a couple of bond types.
What are municipal bonds?
Municipal bonds are issued by a city to complete a specific project. There are several types. A general obligation bond is paid back by taxes. This makes it an incredibly safe investment, unless the whole town goes bankrupt. A revenue bond is paid back by money from whatever project it funded. So if you bought a bond to build a toll road, or an amphitheatre, only money that project actually earned would go towards paying you. Revenue bonds usually have higher interest rates to make them more appealing, but they're also higher-risk, since they're not backed by the "full faith and credit" of the city. Both of these bonds are tax-free on a federal level, and are often (but not necessarily) tax-free on a local level. There are also Build America Bonds. These are municipal bonds that pay more, but are taxed. We'll talk about that in a bit.
What about taxable bonds?
While there are some taxable government bonds, taxable bonds are usually corporate bonds. The payoff is usually higher, but it comes at a price - the risk is greater, since companies can fail in a way that cities don't often do. Plus, there's the income tax hit.
And these Build America Bonds?
Build America Bonds combine the security of government bonds with the higher interest rates of corporate bonds. The government subsidizes them to make it easier for cities and towns to borrow, and the interest rate makes it appealing to a wider variety of people.
So which is better?
Well, as is often the case, there's not a one-size-fits-all answer here. There's the risk factor to consider, and that's a matter of personal preference. But the big factor is your tax bracket. Knowing how much you're going to get taxed is the key that tells you whether it's better to go with the higher interest rate, or the tax hit.
That sounds complicated and obnoxious.
Well, the good news is, there's a simple equation that can make it easier for you. It's called Tax Equivalent Yield, and it lets you compare taxed and non-taxed bonds.
Tax-Equivalent Yield = Tax-Exempt Interest Rate/(100-Your Federal Income Tax Rate)
That may look complicated, but it's pretty easy. Let's start with 100, and subtract your tax rate in your bracket. That gives you your reciprocal, or "how much money you've got once Uncle Sam's finished digging in your pocket." So now
Tax-Equivalent Yield = Tax-Exempt Interest Rate/Reciprocal
Cool, so we look at the interest rate on that bond you've been eyeing, and divide it by whatever's left after taxes. You should get a decimal you can turn into a percentage. You need to hit that rate to break even with a taxable bond.
Say your tax bracket is 25%. 100-25, your reciprocal is 75. You're looking at a 5% municipal bond. Tax-Equivalent Yield = 5/75, or .0667. So, 6.67% is the rate you'd need on a taxable bond to break even. If you can't find anything better than that, stick with muni.