Tax-Free Municipal Bonds and Rate of Return

"Municipal bond" is a catch-all term meaning bonds sold by state and local governments. You'll often see municipal bonds referred to as "munis." The interest on municipal bonds is usually tax exempt. Consequently, they may offer a better investment opportunity than taxable corporate or Treasury bonds, although these usually offer higher pretax yields.

Munis, Coupons and Taxes

There are two major kinds of municipal bonds. General obligation bonds are backed by the taxing power of the issuing government. Revenue bonds depend on income generated by a project to pay interest and repay the bond. Interest from both types of munis is exempt from federal income taxes if the bonds are used for a purpose that provides a benefit to the general public such as building a school or hospital. In contrast, bonds sold to finance a sports stadium or replenish a pension fund would not be tax exempt. If you are a resident of the state where the bonds are issued, you might not have to pay local or state income taxes on the interest you earn. Municipal bonds typically pay a fixed dollar amount each year, called a coupon. The coupon rate is a percentage of the bond's face value. Suppose the coupon rate is 4 percent and the face value is $5,000. The coupon equals the face value multiplied by the coupon rate, or $200.

Municipal Bond Yields

Municipal bonds are traded on the open market like corporate and Treasury bonds. Consequently, the price you pay will likely be different than the face value. The price you pay for a muni determines your actual rate of return or yield. Yield is equal to the coupon divided by the price and multiplied by 100 to convert to a percentage. Suppose a $5,000 face value municipal bond with a coupon of $200 sells for $4,500:

($200/$4,500) * 100 = 4.44 percent yield

The lower price results in a higher yield because you get the same dollar amount of interest with a smaller investment. Conversely, if the price is more than face value, the yield will fall below the coupon rate.

Tax-Equivalent Yield

It can be tricky to compare rates of return for municipal bonds and taxable bonds since the after-tax yield of a taxable bond is the amount you get to keep. Use these steps to calculate tax-equivalent yield:

Subtract your marginal tax rate from 1. Marginal tax rate is your income tax bracket -- the highest rate of federal income tax you pay. For example, if your marginal tax rate is 28 percent, subtract 0.28 from 1.0 to get 0.72.

Subtract your state/local marginal tax rate as well if the municipal bond interest is exempt from these taxes. If the state tax rate is 7 percent, subtract 0.07 from 0.72, leaving 0.65.

Divide the result from Steps 1 and 2 into the yield of the municipal bond. If the yield is 4 percent, dividing by 0.65 gives you a tax-equivalent yield of 6.15 percent. The answer is the pretax yield a taxable bond needs to produce the same after-tax rate of return as the municipal bond.