Here's how you determine whether a muni is right for your client:

  1. Determine the current yield your client is getting, or can get, from a corporate bond. For this example, let's say that is 10%.

  2. Determine your client's income tax rate. The best way to do this is to ask your client or her accountant. For now, let's say it is 40%. (You may be thinking that the maximum income tax rate in the United States is 38.6%, but remember, that is the federal rate - the states and other taxing authorities take their bite as well.)

  3. Subtract the tax rate from 1. In this case, the result is 0.6 (1 minus 0.4).

  4. Multiply the current yield from step 1 by the result of step 3. Your final result is 6% (0.1 times 0.6 equals 0.06).


This example shows you that, to someone who pays 40% of income in direct taxes, a tax-exempt muni yielding 6% is just as good as a taxable bond yielding 10%. Therefore, if the best taxable yield you can get this client is 10%, but you can get her a 6.1% muni, you should recommend the muni.

Equivalent Taxable Yield
You must be able to do the above calculation backward to compute the equivalent taxable yield:

  1. Determine the current yield your client is getting, or can get, from a muni. To keep the analysis symmetrical, let's say that is 6%.
  2. Determine your client's income tax rate, as above, and let's keep it at 40%.
  3. Subtract the tax rate from 1. Again, that is 0.6.
  4. Divide the tax-exempt yield from step 1 by the result of step 3. Our final result is 10% (0.06 divided by 0.6 equals 0.1).

Muni yields are usually stated in terms of yield to maturity, expressed at an annual rate. Yield to maturity, the total return received by holding a bond until it matures, equals the interest the investor receives from the time he or she purchases the bond until maturity, plus any gain or loss from purchasing the bond at a premium or discount, respectively. Corporate bond yields, on the other hand, are quoted as a percentage of par value.


Exam Tips and Tricks
There is a staggering amount of legislation governing munis. As a Series 7 candidate, you need to be aware of it, but you do not need to be an expert in it. You do need to know that no muni hits the market without a legal opinion by a specialized bond counsel concerning the validity of the following:
  • The issuer\'s statutory authority to float the bonds,
  • The constitutionality of the purpose of the funds raised,
  • Procedural conformity, and
  • Federal tax exemption.



Long Term Munis

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