Rebecca Katz: Okay, great. Our next question is from—oh, its a good follow-on question, from Steve in Columbus, Ohio. Thanks, Steve. What is the role of munis in the taxable portion of a diversified portfolio? How do they fit into your overall bond allocation? So now were getting more specific. You know you need bonds for diversification and to minimize volatility. How much muni versus taxable?
Daniel Wallick: Right. A lot of this is going to drive off of a couple things. One, whats your risk tolerance. We talked earlier about the different types of bonds. Lets just talk about the three big buckets. You can have Treasuries, which are guaranteed by the U.S. government. You can have municipals, which are guaranteed by a state or local government, or you can have corporate bonds, which are guaranteed by some private company.
The risk level is: the U.S. bonds are most secure, right, U.S. Treasuries are the most secure; munis are next; and then corporates are there. So where are you in terms of that comfort level of how much risk youre willing to take? Its really the first question to ask.
The second one is, Whats the yield on munis, whats your tax rate, and how does that relate to the other options you have, and is it a valuable investment based on that?
Rebecca Katz: Right. I believe we have a chart we can show you on how to calculate what we call the taxable-equivalent yield, correct?
Chris Alwine: Yeah. If we could bring up that slide to go through it. Now, it looks a little busy up there, but if you look at the top formula, the tax-equivalent yield equals your muni yield divided by one minus your tax rate. Your tax rate, though, is the combined tax rate. It would be your top marginal federal tax rate, as well as state, and then also the Affordable Care Act. This is a new tax that was instituted in 2013 for investment earnings. Now, munis are exempt from that.
What we did here is we took an example. A 10-year A-rated muni today yields about 2.80%. Someone in the top tax bracket would be paying 0.434% tax rate, so one minus that percentage. We divide that out, and we get 4.95%. Now its important to keep in mind when were looking at tax-equivalent yields, we need to compare them to a similar alternative in taxable space. Daniel brought up the different risk spectrums, so if we were to calculate the tax-equivalent yield of a high-yield muni to a Treasury security, that would not be a fair comparison. One has a lot more risk than the other. So A-rated to A-rated, AA to A, those types of comparisons make more sense.
Now for the mathematically inclined, I will give a differing variation for that. Its not up on the screen, but your break-even tax rate would be one minus the muni yield divided by the taxable yield. For those who want to manipulate the formula, who prefer to do algebra, its out there to give it a try. But one minus the muni yield divided by the taxable yield gives you your break-even tax rate.
Rebecca Katz: Okay, great. Well, we actually have a good follow-up question around break-evens, actually. This is from Timothy in New York, and he says, Analyzing break-evens between taxable and tax-exempt bonds, does it make sense sometimes for someone not in the highest marginal tax rate to invest in munis? Daniel, why dont I throw that one to you?
Daniel Wallick: It can. One is, Whats the absolute level of muni yields? So, where are they actually trading? The other is, Whats your tax rate, your tax level? Again, going through the math that Chris just articulated, you can figure out if its a benefit relative to the other options that are out there.
I will go back and just reiterate what Chris said. Its really important to be comparing apples to apples, here. There may be something that looks attractive on a yield basis, but whats underlying that that we dont recognize is theres actually more risk associated with that. That may be a perfectly rational decision to make, but you want to make that consciously, not subconsciously.
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