Incidentally, for those of us in states with state-level income taxes, the increase in interest rates over the last several years should potentially instigate another reflection on the relative value of corporate and treasury bonds in taxable accounts themselves. Corporate bond yields are a function of risk free treasury rates plus a credit spread. As interest rates have increased, the tax benefit associated with holding treasuries relative to corporates has grown while credit spreads—which are pricing risk of default and loss given default at present value—have very little relationship to the absolute level of yields (and are low by historical standards).
To illustrate with a concrete example, take a 1.5% treasury, exempt from state taxation. If credit spreads over the same horizon are 1% (ie. an all-in yield of 2.5%, 1.5% risk free + 1% spread), in a state with a 10% marginal rate said corporate bond or index would yield 2.25% after state taxes. Net, the corporate earns 0.75% more after accounting for state taxes of course.
Fast forward to a 4.5% treasury environment with the same 1% credit spread, similar to what we see today. The 4.5% treasury continues to earn the same after state taxes, but the corporate earning 5.5% now losses an entire 0.55% (5.5% x 10%) to state taxes, resulting in an after-state-tax yield of 4.95%, an advantage of just 0.45% relative to the treasury! But of course the risk of default or loss given default haven’t of course improved for the corporate to compensate for the diminished after-tax spread (if anything they’ve arguably deteriorated)!
One implication, particularly for those holding BND with significant unrealized losses, would be to own treasuries and corporates separately in a taxable account in today’s market.
To illustrate with a concrete example, take a 1.5% treasury, exempt from state taxation. If credit spreads over the same horizon are 1% (ie. an all-in yield of 2.5%, 1.5% risk free + 1% spread), in a state with a 10% marginal rate said corporate bond or index would yield 2.25% after state taxes. Net, the corporate earns 0.75% more after accounting for state taxes of course.
Fast forward to a 4.5% treasury environment with the same 1% credit spread, similar to what we see today. The 4.5% treasury continues to earn the same after state taxes, but the corporate earning 5.5% now losses an entire 0.55% (5.5% x 10%) to state taxes, resulting in an after-state-tax yield of 4.95%, an advantage of just 0.45% relative to the treasury! But of course the risk of default or loss given default haven’t of course improved for the corporate to compensate for the diminished after-tax spread (if anything they’ve arguably deteriorated)!
One implication, particularly for those holding BND with significant unrealized losses, would be to own treasuries and corporates separately in a taxable account in today’s market.
Statistics: Posted by Pretsler — Sun May 19, 2024 10:58 pm — Replies 31 — Views 3286