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By Christine Benz | 02-15-2012 01:00 PM

Muni or Taxable Bond? Our Calculator Crunches the Numbers

Morningstar's Christine Benz demonstrates how our Tax-Equivalent Yield Calculator can help you determine whether you're better off investing in taxable or municipal bonds after adjusting for munis' tax-exempt status.

Christine Benz: Hi, I am Christine Benz from Morningstar.com. One of the key steps to take when evaluating whether you are better off in taxable or municipal bonds is to look at the two yields and see whether you are better off in the taxable bond or the muni once you consider the fact that you're earning a tax break on the municipal bond or bond fund. I'll show you how to do that using the tax-equivalent yield function on Morningstar.com's Bond Calculator.

The starting point for doing this comparison is finding the yields for the taxable-bond fund you'd like to look at, as well as the municipal-bond fund. So let's start by entering a ticker for a widely held taxable-bond fund and finding its yield on the site. We can see that its yield is 4.12%. If you would like an even more current snapshot of the fund's yield, you can go to the fund company's website and look for a statistic called SEC Yield. But this statistic on Morningstar.com will work as well.

You can also then find the yield for a municipal-bond fund with a similar risk-reward profile. So here's Vanguard Intermediate-Term Tax Exempt. You can see that its yield is 3.41%. Again, if you wanted, you could go on to Vanguard's site to find an even more current statistic called SEC Yield. But armed with these two data points, we can then switch over to Morningstar's Bond Calculator, which is on the Tools cover page of the site; it's down toward the bottom. We want to click on this link that says "Tax-Equivalent Yield."

On this screen, we'll see that we need to enter the yields for the municipal-bond or bond fund, as well as the yield for the taxable-bond fund. So in this case, the municipal fund's yield was 3.41%, and then the taxable fund's yield is 4.12%. Then we need to enter our own tax bracket; you of course want to customize this based on your own tax bracket, as well as your state tax rate. I'll enter Illinois' state tax rate of 5%, and then with the municipal bond you have to answer whether the interest you earn is exempt from state and local taxes. Because we're looking at a municipal national fund here, I would enter "No" because I could only earn a state tax break on a single-state fund, a fund dedicated to my home state.

Then next to the taxable bond attributes I need to answer whether it's a Treasury bond. The fund that we're looking at, Vanguard Intermediate-Term Investment Grade, is not a Treasury-bond fund, so I would enter "No." Then I would click calculate, and the tool shows you what the tax-equivalent yield for the municipal-bond fund looks like relative to the taxable fund's yield. So, what you are looking at here is essentially a figure that is grossed up for the municipal fund to account for the tax break that you receive on muni income. You'll see that in this particular case, the tax-equivalent yield for the municipal fund is actually higher than it is for the taxable fund.

Of course, there are a lot of other different considerations that go into determining whether you will opt for a municipal-bond fund or a taxable-bond fund. Certainly, you'd want to think about where you are holding the assets, and there's almost never a reason to hold a municipal bond or bond fund within a tax-sheltered wrapper like an IRA. You will also want to consider other factors, such as the quality of the management team, the overall risk-reward profile, and the strategy going on at the fund, and all of the other due diligence that you would always do when considering an investment would go into play here. But this tax-equivalent yield function is a handy way to get your arms around whether you are better off, from a pure yield basis, investing in the municipal bond versus the taxable bond.

One last caveat, if you are comparing taxable- and municipal-bond funds, you want to take care to make sure that you are comparing apples to apples. For example, you wouldn't want to compare a low-quality municipal-bond fund with a Treasury fund; the risk-reward characteristics are simply too different to make that a worthwhile comparison.

Thanks for watching. I am Christine Benz for Morningstar.com.

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