Changes in federal income tax rates under the 2001 tax act have complicated what was once a fairly straightforward and effective marketing tool for municipal bond sales -- taxable-equivalent yield calculations.
Investors have long relied on taxable-equivalent yield calculations as a means of making apples-to-apples comparisons between the after-tax returns offered by taxable and tax-exempt bonds. What it does is derive the yield that an investor must receive on a taxable bond to obtain the same after-tax return available on a given tax-exempt bond.
The calculation has become so integral to the marketing of municipal bonds that in recent years many firms that sell the securities to investors have even installed tax-equivalent yield charts and calculators on their Web sites.
Traditionally the calculation is made by subtracting an investor's tax rate from 1, and dividing the yield on the given municipal security by that figure. However, under the new tax act, tax rates are set to change three times between 2001 and 2006. Then, in 2011, they revert back to the 2000 levels, unless extended by Congress, as current lawmakers intended upon passage of the bill.
But the calculation has always relied upon tax rates remaining constant. So changes in tax rates under the new law effectively renders the calculation inaccurate over the life of a bond.
The issue has gone either unnoticed or ignored by some, while those seeking to adapt the calculation to changing tax rates are increasingly finding themselves tangled up in yields.
One firm that has just recently begun to formally address the issue, however, is Prudential Securities Inc. Over the past two weeks, the firm has been circulating a report among branch managers -- which has also been posted on its Web site -- explaining the problem and detailing just how taxable-equivalent yields should be calculated.
In the report, author Evan C. Rourke, municipal market strategist at the firm, detailed a system he designed that essentially derives an average weighted taxable-equivalent yield for the life of a given bond.
An example he cites is a bond maturing on July 1, 2010, with a yield of 4.5%.
For an investor in the highest tax bracket, half of 2001 must be accounted for at a tax rate of 39.1%, 2002 and 2003 at a rate of 38.6%, and 2004 and 2005 at 37.6%. Then, 2006 through 2009 plus half of 2010 must be figured out at a rate of 35%. Assuming that that investor stays in that same tax bracket until maturity, his average income tax rate over the life of the bond would be 36.6%.
That value can then be plugged into the traditional taxable-equivalent yield calculation as a constant tax rate, and would ultimately generate a 7.1% taxable-yield equivalent.
The formula, according to Rourke, can help avoid costly mistakes for some investors.
In the example cited, "had we used the current tax rate, the taxable equivalent yield would have been overstated at 7.39%," he wrote. "If we had used the tax rate at maturity, the taxable equivalent yield would be understated at 6.92%."
In general, "the higher the yield, the bigger the miscalculation," Rourke said in an interview last week. While the example cited in his report was not an extreme one, the taxable equivalent yield for a 10- to 15-year bond with a 5% coupon could easily be miscalculated by 20 to 30 basis points without taking into account the incremental tax rate changes.
Prudential is certainly not the first firm to begin adopting a similar system.
Warren Gisser, a vice president and director of marketing at JB Hanauer & Co. in Parsippany, N.J., said that although his firm has not instituted any formal system incrementally changing tax rates do become part of the conversation between brokers and clients.
"If somebody wanted to pursue that calculation, it would be done on a weighted average basis," he added. Tom Quinn, a certified financial planner and senior vice president at the firm, described a calculation he uses that is identical to that being adopted by Prudential.
In many corners of the industry, however, the issue has been left unresolved. A new brochure, which will be made available later this week by The Bond Market Association, probes into just how the 2001 tax act affects municipal bond investments.
In a question-and-answer format, the brochure tackles such issues as how municipal bonds may help some investors avoid being subject to the itemized deduction limit and personal exemption phase-out by keeping their adjusted gross income below the levels at which these provisions apply. Also, the brochure states that the tax act expands the portion of the population not subject to the alternative minimum tax, and thus eligible to take advantage of the premium in yield offered by bonds taxable under the AMT.
On the top of TBMA's list, however, is how reductions in the top tax rates will decrease municipal bonds' taxable-equivalent yield.
There is one chart in the brochure detailing the incremental changes in tax rates between now and 2006. And there is also another chart that calculates the taxable-yield equivalents for tax-exempt bonds for the different tax brackets -- but they are two different charts and the latter relies on constant tax rates, the ones being phased-in in 2006.
The taxable equivalent yield calculator on the association's Web site, though updated to reflect 2001's new tax rates, also utilizes only constant tax rates, like dozens of other taxable equivalent yield charts on securities firms' Web sites across the industry.
Michael Dorfsman, a spokesman for TBMA, said during a phone conversation this week that the association is aware of the issue, and is considering how to best deal with it.
Not all firms agree that using a constant tax rate in taxable-equivalent yield calculations is really a problem, however.
Merrill Lynch & Co. still uses current tax rates as a constant in calculating taxable-equivalent yields for clients, according to Hugh Hurley, fixed-income manager for the firm's municipal products group.
By no means is it alone in its approach. Taxable-equivalent yield charts that do the same abound on Web sites for firms that specialize in municipal bonds, like Lebenthal & Co. in New York City and American Municipal Securities Inc. in St. Petersburg, Fla.
Because changes in tax rates are so small and spread out, they will not have much impact on taxable-equivalent yields, Hurley said, adding that a weighted average could be too "confusing" for investors.
The difference could be even more fundamental.
Both Hurley and Alexandra Lebenthal, chief executive officer and president of Lebenthal & Co., said they had little faith in the permanence of tax rates, even through 2010.
Meanwhile, both Prudential's Rourke and JB Hanauer's Quinn said that they would utilize 2006's finalized rates in their taxable-equivalent yield calculations even after 2011, when the tax breaks are technically set to expire under the act's sunset provision.
"It's an assumption," Rourke said. "But there are some assumptions in the whole process. When you calculate taxable-equivalent yields , you're also assuming individuals stay in the same tax bracket."
