Tax-Exempt Bond
A bond whose interest payments are exempt from federal income tax, and often state and local tax for in-state holders.
What is Tax-Exempt Bond?
A tax-exempt bond is a debt security whose interest income is excluded from federal income tax under the Internal Revenue Code, and typically from state and local taxes for residents of the issuing state. Municipal bonds (munis) are the most common type, issued by states, cities, counties, and other government entities to finance public projects. Because of the tax advantage, tax-exempt bonds offer lower nominal yields than comparable taxable bonds; investors compare them using the tax-equivalent yield (TEY), which adjusts the muni yield to a pre-tax basis for comparison.
Example
An investor in the 32% federal tax bracket evaluates a municipal bond yielding 3.5%. The tax-equivalent yield is 3.5% ÷ (1 − 0.32) = 5.15%. This means the muni bond is equivalent to a 5.15% taxable bond for this investor, making it attractive compared to a 4.5% corporate bond of similar credit quality.
Source: IRS — Tax Exempt Bonds