DEFINITION of 'Taxable Bond'

A taxable bond is a debt security whose return to the investor is subject to taxes at the local, state or federal level, or some combination thereof. An investor trying to decide whether to invest in a taxable bond or tax-exempt bond should consider what s/he will have left in income after taxes are taken.

BREAKING DOWN 'Taxable Bond'

The majority of bonds issued are taxable bonds which are securities that have their interest payments to investors taxable at either the federal and/or state level. Fixed or variable interest on a bond is income paid to bondholders as compensation for lending the issuer funds for a fixed period of time. The coupon payments are usually made annually, semi-annually, or quarterly depending on the terms and conditions highlighted in the bond purchase agreement.

At the end of the year, interest income earners are required to include the amount of interest received on the bonds. If the bonds were issued at a discount and held until maturity at which point it was redeemed for face value, the bondholder will be liable for taxes on the spread. Consider a zero-coupon bond and Treasury bill which do not pay interest for the duration of the bond’s life. Instead they are offered at discounts and redeemed at par value on the maturity date. For example, an investor may purchase a bond for $950 and receives $1,000 face value at maturity. The $50 difference represents the return on the investment and is taxed as interest income. Even though the bondholder does not receive interest income per se, the discount is considered imputed interest by the Internal Revenue Service (IRS) and must be reported at the end of the tax year. However, if the discount bond is sold before maturity, a capital gain or loss will ensue which must be reported in order to be taxed accordingly.

All corporate bonds and some government bonds are taxable bonds. For example, Treasury securities are taxed at the federal level, but tax-exempt from local and state taxes. Municipal bonds, on the other hand, are not taxed at the federal level and may also be exempt from state taxes if the bondholder resides in the state where the bonds are issued.

Some municipal governments issue taxable bonds to finance projects that do not benefit the public at large. Interest from municipal bonds issued to finance projects with no obvious public benefits is taxable since the federal government will not subsidize the financing of these projects. Since income from such bonds is taxable in the hands of the investor, taxable municipal bonds offer risk-adjusted yields that are comparable to those available from other taxable entities such as corporate bonds and other government agency bonds. For example, some universities, through municipal authorities, may issue taxable bonds to finance the building of new facilities or expansion of some department wings. These bonds, however, return the market rate as opposed to the lower return rate offered by tax-free bonds.

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