Adjusting for inflation — and, crucially, for taxes — shows bond investors fare better than they might think
Many income-seeking investors feel like they've spent the last nine years wandering in the desert — a yield desert, as interest rates mostly stayed near record lows.
And the recent uptick in rates isn't much solace. But new research suggests that the interest rate picture after the 2008 financial crisis wasn't the Sahara that investors came to believe.
The discrepancy is between nominal interest rates (what you're paid) and real rates, which are what you've got left with after both inflation and taxes.
In a working paper, Daniel R. Feenberg of the National Bureau of Economic Research, Clinton Tepper, a UCLA Anderson Ph.D. student, and UCLA Anderson's Ivo Welch posit that investors have to take both inflation and taxes into account. And omitting the tax hit significantly distorts true interest returns for many investors, they say.
One challenge in assessing true returns is calculating an average tax rate for bond holders who are subject to taxes (as the study notes, many big investors such as pension funds aren't taxed). The authors use two methodologies. One looks at a large sample of federal tax returns that disclose key data without revealing taxpayers' identities. The other approach is to calculate an "implied" tax rate for investors based on the yield difference between taxable Treasury bonds and tax-exempt high-quality municipal bonds.