One Thing You Might Not Know About TreasuriesAugust 14th, 2012 by The Financial Lexicon
Did you know that the advertised rates for U.S. Treasuries, the rates you read and hear about in the financial press, are not an accurate reflection of the taxable-equivalent yield Treasuries provide? The truth is that when you hear about a 1.66% 10-year Treasury or a 2.75% 30-year Treasury, those yields are lower than a true apples-to-apples taxable-equivalent comparison between Treasuries and other bonds would reveal.
When investors discuss municipal bond yields, it is usually in the context of the taxable-equivalent yield. After all, municipal bonds are, for the most part, not subject to federal income taxes. In some cases, they are even exempt from state and local income taxes. Therefore, if you want to compare a muni to a fully taxable bond, you would recalculate the yield to find the muni’s taxable-equivalent yield. The way this calculation is done is by taking the yield on a bond and dividing it by the difference of one and the tax rate you pay (expressed as a decimal). For example, if you buy a bond yielding 3% and your tax rate is 25%, the taxable-equivalent yield is 4%.
With this in mind, why is it that financial pundits never seem to do the same calculation for Treasuries when discussing Treasury yields? After all, Treasury interest is exempt from state and local income taxes. Therefore, comparing a Treasury yield to the dividend yield of a stock or to another fully taxable bond is not a fair comparison. Perhaps the wide variety of possible tax rates across the states and localities is the reason we don’t usually hear about a Treasury’s taxable-equivalent yield. However, that doesn’t mean it’s correct not to provide a taxable-equivalent yield when discussing Treasuries.
Depending on where you live and your income level, your combined state and local income tax rate could be in the double-digits. And, with states and localities grappling with seemingly never-ending budget concerns, it wouldn’t be surprising to see state and local income taxes rise over the coming years. At a 10% state and local income tax rate, a 1.66% Treasury has a taxable-equivalent yield of 1.844%. A 2.75% 30-year Treasury has a 3.056% taxable-equivalent yield at a tax rate of 10%. In 2009, 2010, and 2011, the 30-year Treasury spent time above 4.75%. This meant some investors were passing up opportunities to own a U.S. government bond at taxable-equivalent yields above 5.25%. And this was in the post-2008/2009 financial crisis world, a world in which investors have been flocking to any type of higher-yielding income-producing asset they can find.
Even if today’s Treasury yields are too low for your liking, as they are for me, keep this in mind for the next time yields jump. When you’re comparing yields across various income-producing assets, don’t forget to calculate the yields on an apples-to-apples basis. Based on the manner in which I frequently see Treasury yields discussed, it’s clear that many investors do not do this.
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