In Monday’s article, “HYD: A Rare Opportunity In This Municipal Bond ETF,” I noted the significant discount to its net asset value at which HYD was trading, and I outlined several key features of the fund. On Monday morning, the discount to NAV smashed through its previous all-time high, actually widening to more than 9% at one point. The fear among investors in interest-rate sensitive investments is palpable. And it is creating opportunities all over the fixed income markets. In the aforementioned article, I also noted that I would later discuss the importance of municipal bond investors having an understanding of taxable-equivalent yields, private-activity bond interest, and the Alternative Minimum Tax (AMT). I would like to do so in this article, beginning with taxable-equivalent yields.
The taxable-equivalent yield (TEY) is a number that better compares the yields of a fully taxable security to a security exempt from certain taxes. It is calculated by taking the yield being offered on the tax-exempt security and dividing it by the difference of one and the sum of the tax rate(s) to which you are subject that is exempt for the purposes of the investment in question. For example, if you are subject to 6% state and local income taxes, and you are interested in calculating the taxable-equivalent yield of a 3.60% yielding 30-year Treasury, the computation would look like this (Treasury interest is exempt from state and local taxes):
3.60% / (1 – 0.06) = 3.83%
Therefore, in order the match the yield of a 3.60% Treasury, you would need to find a security paying interest subject to federal, state, and local income taxes with a yield of 3.83%.
Concerning municipal bond interest, investors typically calculate the taxable-equivalent yield by taking the yield of the municipal bond (or bond fund) and dividing it by the difference of one and the federal income tax bracket in which that investor finds him- or herself. But this is incorrect. As those who have already read the municipal bond subsection of Chapter 4 of my book, “The 5 Fundamentals of Building a Retirement Portfolio,” know, it is your federal tax rate, not tax bracket, that should be used when calculating the taxable-equivalent yield of a security. And financial websites all over the web get this wrong. Just because you are in the 25% tax bracket does not mean that all your earnings are taxed at 25%. As I illustrated in my aforementioned book, your actual tax rate is often significantly less than the tax bracket in which you find yourself. Therefore, when calculating HYD’s taxable-equivalent yield, be sure to look at prior tax returns to get a good idea of what your actual tax rate is rather than relying on the tax bracket in which you fall. And remember not to take into account any long-term capital gains you may have had in one tax year that you might not have in the future. After all, long-term capital gains may be pulling down your overall tax rate.
With a 30-day SEC yield of 5.01% (as of 6/21/13), there is a very good chance your taxable-equivalent yield will be higher than HYG’s or JNK’s SEC-yields of 5.23% and 5.49% respectively. But even though, at first blush, HYD currently offers enticing taxable-equivalent yields that, for most investors, easily surpass those of HYG and JNK, there are a couple of additional wrinkles to keep in mind. Interest on “private activity bonds” is not excluded from income for federal income tax purposes unless the bond is considered a qualified bond. According to the “2012 Supplemental Tax Information” document found on VanEck’s website, in 2012, HYD paid 12 monthly distributions totaling $1.6406 per share. Of the $1.6406 in distributions, $0.023466 was considered ordinary dividends for tax purposes while the remaining $1.617134 was considered tax-exempt interest dividends. The reason that $0.023466 of the 2012 distributions was not considered exempt for federal income tax purposes is that it came from non-qualified private activity bonds.
Additionally, of the $1.617134 that was considered exempt interest dividends for federal income tax purposes, 19.39% came from private activity bonds that, while considered “qualified,” are still subject to the rules of the Alternative Minimum Tax (AMT). Therefore, if you are subject to the AMT, the benefits of investing in HYD are considerably less than they would be if you weren’t subject to the AMT because you wouldn’t be able to claim 19.39% of the “exempt” interest dividends as exempt interest dividends.
Rather than having the entire $1.6406 of 2012 distributions exempt from federal income taxes, as some investors might assume, the actual amount of HYD’s distributions exempted from federal taxes was less. For those investors not subject to the AMT, 98.57%, or $1.617134, of the 2012 distributions was exempt from federal income taxes. Those investors subject to the AMT were able to claim as exempt only $1.303571717 of the $1.6406 in total distributions. This implies the recent 5.01% SEC-yield is not actually a 5.01% fully federal tax-exempt yield. It is incredibly important to keep this in mind when calculating the true tax benefit of investing in HYD. Private activity bond interest and the AMT can dramatically change the benefits of investing in municipal securities.
So if you are in the more complicated scenario of being subject to the AMT tax, how do you calculate your taxable-equivalent yield for an investment in HYD? Here’s how:
For illustration purposes, I will use last year’s $1.6406 distribution and the 79.46% figure that was the final amount exempted from federal taxes after accounting for the AMT.
First, take the total amount of expected distributions and multiply it by the percentage of expected post-AMT exempted interest dividends. In this case, take $1.6406 and multiply it by 0.7946. That gives you $1.3036, the amount exempted from federal taxes in 2012.
Next, divide $1.3036 by the difference of one and your actual tax rate. Let’s pretend your actual tax rate (not tax bracket) is 22%. $1.3036 / (1 – 0.22) = $1.67.
Moving along, add to $1.67 the difference between $1.6406 and $1.3036. This difference, $0.337, is an amount that you were paid, but wasn’t exempt from taxes. $1.67 + $0.337 = $2.007.
Finally, take $2.007 and divide it by your cost basis in HYD. This will give you your taxable-equivalent yield.
I have yet to find an investment in life that I consider perfect and without risk. HYD is no exception. But if you can look beyond some of the short comings regarding taxes (the AMT, for example), and you are simply looking for steady bond income at respectable yields, the recent selloff in HYD and the dislocation from its net asset value is a buying opportunity.
For more information on private activity bonds, see Title 26, Subtitle A, Chapter 1, Subchapter B, Part IV, Subpart A, § 141 of the United States Code.
More from The Financial Lexicon:
Income Investing Insider Newsletter
The 5 Fundamentals of Building a Retirement Portfolio
Options Strategies Every Investor Should Know