Municipal bond question

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ymc

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I came across a Schweser question that looks like this:

An investor in the 28 percent tax bracket buys a 20-year, 4 percent municipal bond for $750. What is this bond's taxable equivalent yield?
A)5.56%.
B)6.22%.
C)None of these are correct.
D)9.62%.

It says the answer is C) because you can't determine the TEY unless the municipal bond is selling at par.

If that's the case, how do people compare municipal bonds to normal bonds in real life?
 
This sounds wrong. The question asks for taxable equivalent yield, not coupon. In the real world it's based on the yield.
 
You mean the answer shouldn't be C)?
 
I get a YTM of 6.198 for this bond, which would be a 8.608% taxable equivalent (6.198/.72). But that's not one of the answers. I would email Schweser on this one.
 
I think we had this question before and I don't like it. Of course you can make estimates of TEY on munis not selling at par. The issue here is that you don't know if the bond is an OID bond (and gains to par are treated as interest income which is not taxable) or a discount bond because, say, it's backed by revenue from freeway bridge that is closing down (in which case a pay-off at par is taxable capital gains). And of course, it could be an OID bond trading at a discount or premium and that makes things even more complicated. The answer C) is probably correct but the reasoning isn't right.
 
I thought this was the forumla to calculate the TEY.
Taxable-equivalent yield = tax-exempt yield / (1- marginal tax rate)

Substituting,
TEY = 0.04/(1-0.28) = 0.055556

so the answer should be A) 5.56%

I still dont understand how 'C' could be possibly the answer?

Thanks,
Dinesh S
 
I haven't read the Schweser text on this, but that's from my Series 7 notes:

If a muni is purchased at discount in the secondary mkt, meaning the discount is caused by market conditions, there will be a taxable gain at maturity because of the appreciation of value to par. The gain is reported as ordinary income.

For an Original issue discount bond (OID) the appreciation in value is treated differently, because it's really based on interest rates. (Think of a zero-coupon bond, the difference between the purchase price and par is the ineterest payment). The discount for an OID is being accreted each year and the accreted amount treated as interest, therefore no tax on it.

You can't determine TEY because you don't know which one of these two you have.
 
So what is the TEY if OID or non-OID?
 
ymc Wrote:
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> So what is the TEY if OID or non-OID?

Work it out. Suppose the bond is OID with a 4% coupon selling at $750 with par = $1000. All the interest is tax free and use the formula. If there was no OID then interest is not taxable but the taxation depends on what happens to the bond and when you sell it.
 
I am still not quite sure how to calculate the TEY for a discounted OID municipal bond.

So for an OID municipal bond, the TEY is 8.63%? If so, does that mean the equivalent taxable bond should sell at $565.54?
 
I'm too lazy to work out exact #'s here, but let's say that we have a 20-yr muni offered at $750 with a 4% coupon and par is $1000 so the yield on this is about 6%. The important thing is that all that discount is OID discount. Now we just use dinesh's formula above

6%/(1-0.28) = 8.3%

BTW - From Dec2007 "If a muni is purchased at discount in the secondary mkt, meaning the discount is caused by market conditions, there will be a taxable gain at maturity because of the appreciation of value to par. The gain is reported as ordinary income. "

I don't know where this came from, but it's not right. The gain is reported as capital gains and taxed accordingly which means that if you hold the muni for more than a year, the gain is taxed at 20%, not ordinary income rates.
 
Joey, that came straight from my study books for Series7. The more detailed explanation says that the appreciation of value to par is taxed as ordinary income (that is, the bond is held until maturity). If it's sold earlier there could be a combination of ordinary income and capital gains tax. Their conclusion is "Like many tax regulations, this rule can be highly complex".


I didn't mean to confuse anyone, there could have been changes, I took S7 in March06.
 
This is such BS. If I buy risky downgraded bonds, why should gain from their recovery be treated as interest income not as capital gains from taking on risk? Further, if you buy munis (I don't, btw) and interest rates go up, you get a double whammy. For example suppose I buy a 7% 10 yr muni at par and the next day interest rates jump to 8%. That bond ought to be worth 93 or so., but that 7 pts is now taxable so if someone is in the 40% tax bracket they would be giving 3 pts over 10 yrs to the govt or about 0.33% of yield which drops a pt or so off the price of the bond compared to other tax free munis and the liquidity must suffer even more because of all the people who buy munis just because they don't want to deal with taxes at all.
 
"Small" discounts will not trigger a capital gain liability due to the de minimis rule.
Under the de minimis rule, if a bond is purchased with a small amount of market discount�an amount less than 0.25 percent of the face value of a bond times the number of complete years between the bond�s acquisition date and its maturity date (so Joey's 10 year bond could realize a discount up to 2.5% in principle, obviously declining as the bond ages)�the market discount is considered to be zero. If the market discount is less than the de minimis amount, the discount on the bond is generally treated as a capital gain upon disposition or redemption rather than as ordinary income.

For the individual investor this is in fact a pain; for the institutional guys there are tax strategies of offsetting gains and losses to attempt a neutral tax effect.


Note: None of my post is LI material.
 
Also, we should not confuse OID with a market discount for tax purposes. OID exists when a bond is issued at a price below its redemption value. OID represents interest paid by the issuer and, for municipals, is generally treated as taxexempt interest. Market discount exists when a bond falls in value after it has been issued. Market discount is not treated as tax-exempt interest because it does not represent an interest expense of the issuer. An OID bond may be subject to the market discount rules if purchased after original issue at a time when the price of the bond reflects a market discount, i.e., if the bond is purchased at a price below its revised, or adjusted, issue price.
 
Char-Lee Wrote:
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> For the individual investor this is in fact a
> pain; for the institutional guys there are tax
> strategies of offsetting gains and losses to
> attempt a neutral tax effect.
>
Like what?

I think this tax rule isn't fair. A totally beaten to heck bond is really close to equity but taxed much worse.



Edited 1 time(s). Last edit at Wednesday, September 12, 2007 at 06:20PM by JoeyDVivre.
 
JoeyDVivre Wrote:
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>
> I think this tax rule isn't fair. A totally
> beaten to heck bond is really close to equity but
> taxed much worse.

I think I'll differ. First, ignore OIDs -- there was a spasm of issuance of them in the early 1980s due to an IRS snafu, but they're generally a dying breed.

For non-OIDs, say Ford's 10% bond is trading at 40; you buy it, hold for 2 years, it's trading at 80 (I don't know how this could happen, maybe Toyota fell into the sea), and you picked up 20 in coupons. The coupons are taxed as ordinary income, as usual; the capital gain of (80-40) is taxed at long-term cap gains.
 
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