Sunday, October 23, 2005

Calculating Tax Equivalent Yields

Pepper and I had a good long discussion at the pool hall about various options for a low-risk income producing investment of $20,000 (LaLa and the gear girl were otherwise engaged in a friendly game of darts...they do not understand our nebbishy ways). We were primarily wondering if I-bonds were suddenly a playa given the recent high CPI-U and the extra bonus of not being taxed by the state on interest. Or was a state municipal bond fund better? Or a taxable socially responsible bond fund?

I was obsessed with doing the math but it was a struggle since I'm still learning. If I've made some mistakes, please let me know!

Tax Equivalent Yield Formula

tax equivalent yield = yield / ( 1 - applicable tax rates)

Operation Parameters
  • Federal Marginal Tax Rate: 25%
  • MA State Tax Rate: 5.3%
  • Amount invested: $20,000

Option 1: I-Bond (5.29%)
Federal tax is deferred on an I-Bond, but it is exempt from MA tax. Since we can't predict the future fixed rates or the CPI-U, I assumed a buy in late October and selling in 14 months. This would count as 15 months and the 3 months of as yet unknown interest would be forfeit. Jonathan has already done all the hard work to figure out the blended rate in this case as 5.02%. Since only state tax can be factored in here, the taxable equivalent yield is 5.29%. The yield is paid out as interest (cash).

Option 2: MA Sales Tax Bond (5.52%)
Digging around the Fidelity site, I found a single municipal bond with a relatively high yield to compare. The current price is $108.511 per $100 so $20,000 would buy 184 bonds ( I think I have that right). The coupon pays 5% so the yield is currently calculated at 3.85%. Because this bond is federal and state tax free, the taxable equivalent yield is just over 5.52%

Option 3: FDMMX (approx 5.82%)
The Fidelity Massachusetts Municipal Income Fund is federal and state tax free. This fund requires an initial investment of $10,000. The current price per share is $12.03 so $20k would by roughly 1662 shares. The dividend is currently $0.04 per share. Given that dividends are re-invested (They *are* reinvested, right? if so, approx 5-6 shares a month added), I ended up estimating a yield of 4.06 which is a taxable equivalent yield of 5.82%

So if my calculations are right I-Bonds don't look that sexy compared to the munis (I-Bonds are sexy for other reasons though including low barrier to entry for such a nice rate) and a taxable bond fund would have to yield at least 5.52% after all expenses and loads were accounted for in order to really compete with municipal bonds...

Or am I all wrong?

[Update: Of course, Dinkytown has a helpful calculator for figuring out TEY on a Municipal Bond]

2 comments:

  1. Thanks for the additional information and clarity hedged.

    My purpose was specifically to try out some TEY calculations, to get a view on comparitive TEYs.

    What isn't clear in the post is that the original question was I-Bonds vs. Calvert Income Fund and I was curious about some of the other comparisons myself so hence the TEY

    And you are also right that I did not include Fidelity's 0.42 expense ratio etc but I'd love to know how to do that math to do that

    Anyone?

    And I'm certainly no financial expert nor do I claim expertise. I'm just a layperson struggling with all this info, so the post was just as much about getting further information as it was about sharing a small piece of my process.

    ReplyDelete
  2. I believe the NAV value of the Fidelity Tax-Free MA Muni Bond fund already is "net" (net asset value) of the expense ratio, so the .04 cent per share yield you indicate already accounts for expenses

    ReplyDelete

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