Saturday, July 28, 2012

Stock vs Bonds, tax comparison, Part 3

In this post, I'll discuss the tax implications of bonds.

Bonds are actually pretty inefficient when it comes to taxation, but hey, it makes sense, because stock dividends are actually double-taxed, once at the corporate level, and once at individual income level, whereas interest payments on bonds are tax-free on the corporate side.

Following the grand theme of 2s, let me introduce you to the two types of bonds: taxable and tax-exempt.

Taxable bonds are fairly easy to understand, their interest payments are taxed at the regular income tax rate, which means 28% federal and whatever state tax. Interestingly, treasury bills are taxable!

Tax-exempt bonds are slightly more complex. Most bonds marketed as tax-exempt actually only means that you are exempt on federal taxation for interest gain. If you state happens to tax your income, then you'll have to pay the state tax. Our beloved California will then get a 9.3% cut of your interest gains. I guess this is the price you have to pay for nice weather and the existence of silicon valley, huh? There is another kind of tax-exempt bond funds, those state specific. Usually, you can only buy state-specific bond funds only if you are a resident of that state. For example, the Vanguard California Long-term Tax-exempt Fund are only available to California residents, but the interest gains from this fund is then also exempt from CA taxation.

Two common misconceptions!

  1. "I bought a tax-exempt fund! Now all my gains are tax free!"
    Not true! As I mentioned, tax-exemption only applies to the interest earnings. If you sell a tax-exempt bond fund, you still have to pay tax on any capital gain. 
  2. "Tax-exempt bonds are always better because I pay no tax!"
    Not true! The ultimate goal of investment is to maximize after-tax return, not minimize tax. If you have two funds with exactly the same characteristics, except A is taxable with 5% yield and B is tax-exempt with 3% yield, then obviously you should take the 5% one. 5% * (1-0.28) = 3.6%.
You may have a question with regard to the 1st misconception, namely, how exactly do you get a capital gain from bonds? Are they not just instrument that generate income? Well, just like stocks' return consist of appreciation and dividend, bonds' return also consist of both. The price of a bond varies with its demand, the higher the demand, the higher the price. If you look at it from another angle, then it can be interpreted as a variation in yield. Let's take a look at an example.

You bought 10k worth of bond at 10% yield (yeah, super bond, or maybe super risky bond), it has a maturity of 10 years. The moment you bought it, suddenly the yield dropped to 0%. (Very unlikely to happen, but we do see zero or even negative bond yields, we've even seen them recently in the case of 3 month US treasury bills and German bunds) Now how much is your 10k bond? Since most of the bonds are fixed rate, your 10% yield will continue to provide 10% annual income for 10 years before the principal is paid back to you. So your 10k bonds in 10 years time will be worth 10k + 10k * 10% * 10 years = 20k. 
Now for people that bought the 0% yield bond right after you, in 10 years time, their bond will be exactly 10k. Therefore, your 10k bond with 10% yield now is exactly the same as 20k bond with 0%. So you can sell your bond for 20k and cash in an extra 10k! This is basically how capital gain occurs. Similarly, when the yield rises, the value of bond you hold will drop. 

Of course, bonds' yield don't change by 10 percentage points every day, most of the time, their price hardly changes. This is especially true for short-term bonds, as even if the yields fluctuate, the impact on the entire value of the bond is small. Take the made-up 10k 10% example again, if the maturity is only 1 year, you'll gain 10% instead of 100%. 

In the next post, I'll summarize what I touched upon, and introduce the concept of what's known as "asset-location". 

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