Suppose taxable bonds are currently yielding 7 percent, while at the same time, munis of comparable risk and maturity are yielding 5 percent. Which is more attractive to an investor in a 30 percent bracket? What is the break-even tax rate? How do you interpret this rate?
In this scenario, taxable bonds with a yield of 7 percent are more attractive to an investor in a 30 percent tax bracket. This is because the investor would have to pay taxes on the interest earned from taxable bonds, reducing their effective yield. With a 30 percent tax bracket, the after-tax yield on taxable bonds would be 70 percent of the 7 percent yield, which is 4.9 percent.
On the other hand, munis with a yield of 5 percent are tax-exempt, meaning the investor does not have to pay taxes on the interest earned. Therefore, the after-tax yield on munis remains at the full 5 percent.
The break-even tax rate is the tax bracket at which the after-tax yield on taxable bonds is equal to the yield on munis. In this case, the break-even tax rate can be calculated by setting the after-tax yield on taxable bonds (4.9 percent) equal to the yield on munis (5 percent) and solving for the tax bracket.
The interpretation of this break-even tax rate is that if an investor's tax bracket is below this rate, taxable bonds would be more attractive. However, if the tax bracket is above this rate, munis would be more attractive due to their tax-exempt status.