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Welcome to the EsqWealth Grand Prix, where high-net-worth investors race towards financial success. In this thrilling event, we have three high-performance vehicles on the track: tax-free municipal bonds, short-term Treasury bills, and long-term Treasury bonds. Each has its own strengths and weaknesses, and the choice of vehicle depends on the driver’s skill, strategy, conditions on the track, and tax bracket. While we often encourage clients to invest in dividend stocks due to their historical outperformance of the S&P 500 with less volatility—thanks to their dual sources of return: dividend payments and capital appreciation—we understand that everyone is unique with different circumstances. This article addresses the tax-equivalent yields and related considerations for the selected vehicles for clients who want to have a portion of their portfolio or their cash in low-risk bonds.

Meet the Racers

First up, we have the tax-free municipal bonds, the endurance racers. They’re in it for the long haul, offering tax-free returns and the thrill of potential capital gains. Next, we have the short-term Treasury bills, the sprinters of the investment world. They’re quick, reliable, and backed by the full faith and credit of Uncle Sam himself. Finally, we have the long-term Treasury bonds, the marathon runners of the race. They’re steady, reliable, and also backed by the U.S. government.

The Willits, California Wastewater Revenue Bond

To compare the horsepower of each racer, we’ll take a look under the hood of one particular municipal bond, the Willits, California Wastewater Revenue Bond. This bond is like a well-oiled machine, designed to fund the development and maintenance of the city’s sewer utility infrastructure. It has a fixed coupon rate of 2.5%, matures on 11/01/2050, and is callable beginning 11/01/2030.

The Starting Line: Current Yields

As our racers rev their engines at the starting line, let’s check out their stats as they were reported as of this writing. The Willits bond has a yield to maturity (YTM) of 4.791% and a yield to call (YTC) of 9.786%. The 3-month Treasury bill is boasting a yield of 5.396%, while the 20-year Treasury bond is not far behind with a yield of 4.752%. So does the 3-month Treasury bill have the most horsepower? Not so fast.

[Commentator interruption: You may be thinking “the author has his numbers off because he just said the Willits bond has a fixed coupon rate of 2.5%, so how can it have a YTM of 4.791%?” Well, the seller of the Willits bond is willing to sell the bond at 65.864% of its face value because interest rates are much higher today than when the bond was issued at 2.5%. In other words, if the face value of the bond is $1,000, investors would pay approximately $658.64 for each bond at this asking price resulting in a higher YTM.]

Pit Stop: Tax Considerations

Back to which racer has the most horsepower. Let’s evaluate that in the pit stop ahead! Our racers have different tax implications. While the interest income from municipal bonds is generally exempt from federal and state income tax (if the investor lives in the same state where the bond was issued), Treasury securities are only exempt from state and local taxes. So, we calculate the tax-equivalent yield (TEY) to compare them on equal footing and to compare them with other bonds that have no tax breaks. With a combined federal and California state tax rate of 50%, the Willits bond’s TEY comes out to a whopping 9.582%. The TEY for the Treasury bill is 6.221% and for the 20-Year Treasury bond is 5.481%.

[Commentator interruption again: here are the calculations for the nerdy types. The TEY Formula is as follows:

Assuming a combined federal and California state tax rate of 50% for municipal bonds, the TEY for the Willits bond is:

For Treasury securities, which are exempt from state and local taxes, we use the highest California state tax rate of 13.3% to calculate the TEY. The TEY for Treasury bills is:

The TEY for 20-Year Treasury bonds is:

It’s important to note that when purchasing municipal bonds at a discount in the secondary market, part of the YTM may be subject to federal taxes as accretive interest. This means the precise TEY for the Willits bond may need to be adjusted for a number of factors including the taxable accretive interest, current market conditions, the holding period, and individual tax situations. This analysis goes beyond the scope of this article. Consulting with a tax professional can provide a personalized TEY estimate that factors in the accrued interest and your specific situation. Now, back to the race…]

The Twist: Interest Rate Outlook

Just when you thought you had the race figured out, there’s another twist! Most economists expect the Federal Reserve to lower interest rates this year and next. When interest rates fall, bond prices typically rise. Thus, falling interest rates should increase the market value of the long-term treasury bond and the municipal bond, leading to potential capital gains. On the flip side, your reinvestment returns may fall when your short-term Treasury bills mature or if you sell your bond.

The Finish Line: Pros and Cons

Like any good race, this one isn’t without its ups and downs. If horsepower (or TEY) was the measure of victory, the Willits bond would take the checkered flag. But remember, higher returns often come with higher risks. Each racer has its own set of pros and cons to consider.

Tax-Free Municipal Bonds

Pros:

• Tax Efficiency: Interest income is exempt from federal and state taxes, providing a higher after-tax return for the Willits bond, but each bond has different credit ratings, yield to call numbers, yield to maturity numbers, etc., so be sure to look under the hood.
• Potential for Capital Gains: When interest rates fall, bond prices typically rise. Therefore, if the Fed lowers rates, the market value of the Willits municipal bond is likely to increase. This means you could sell the bond for a profit, creating a capital gain.
• High Yield to Call: The bond is callable starting 11/01/2030 at par (100). If the bond is called in a declining rate environment, it would result in an attractive yield to call (YTC) of 9.786%. However, this would also mean you stop receiving the interest payments earlier than anticipated.

Cons:

• Credit Risk: While municipal bonds are generally considered safe investments, it’s important to note that they carry a level of credit risk. Unlike Treasury securities, which are backed by the full faith and credit of the U.S. government, municipal bonds rely on the issuing municipality’s ability to generate revenue. While this risk is typically lower than that associated with equities, it is higher than the virtually risk-free nature of Treasury securities.
• Liquidity: Municipal bonds can be less liquid than Treasury securities, making them more difficult to sell quickly without affecting the price.
• Inflation Risk: Long-term bonds are also exposed to inflation risk, as inflation erodes the purchasing power of future bond payments. If inflation rises unexpectedly, the real value of future bond payments may decrease.

Short-Term Treasury Bills

Pros:

• Safety: Backed by the full faith and credit of the U.S. government, making them one of the safest investments.
• Liquidity: Highly liquid with a very short duration, ideal for preserving capital and managing cash flow.
• Current Yield: Offers a relatively high yield in the current interest rate environment.
• Stable Income: Short-term Treasury bills would provide a predictable income stream with minimal price volatility.

Cons:

• Federal Taxable: Interest income is subject to federal tax, reducing the after-tax return.
• Reinvestment Risk: With short maturities, there is a risk that reinvestment rates may be lower if interest rates decline.

Treasury Bonds

Pros:

• Price Appreciation: Like the Willits bond, falling interest rates should result in the market value of Treasury bonds increasing. Thus, you could sell the bonds for a profit, creating a capital gain.
• Stable Income: Treasury bonds offer a steady income stream through regular interest payments until maturity, providing stability for investors seeking predictable cash flows.
• Safety: Like Treasury bills, Treasury bonds are backed by the full faith and credit of the U.S. government, making them one of the safest investment options available.

Cons:

• Federal Taxable: Interest income is subject to federal tax, reducing the after-tax return.
• Inflation Risk: Like the Willits bond, Treasury bonds are also exposed to inflation risk.
• Lower Yields: Compared to other fixed-income securities, such as corporate bonds or high-yield bonds, Treasury bonds typically offer lower yields, potentially resulting in lower returns for investors seeking higher income.

The Winner’s Circle: Making Your Decision

So, who’s the winner? Well, that depends on you. If you’re looking for a quick, safe return, Treasury bills might be your champion. If you’re in it for the long haul and want to maximize your after-tax returns, the municipal bond could be your victor. However, if you seek a stable, predictable income stream, want the lowest risk, and are prepared to hold for a longer term, Treasury bonds might be the ideal choice for you. Remember, at EsqWealth, we’re in your pit crew, ready to help you make the best decision for your financial future. Let’s race towards success!