Nicholson Financial Services, Inc.David S. NicholsonFinancial Advisor89 Access RoadSte. CNorwood, MA 02062781-255-1101866-668-1101david@nicholsonfs.comwww.nicholsonfs.com

Comparing Bond Yields

June 11, 2020

Coupon Rates and Current YieldIf you're considering investing in a bond, oneof the factors you need to understand is itsyield. But it's important to know exactly whattype of yield you're looking at.

What exactly is "yield?" The answer dependson how the term is used. In the broadestsense, an investment's yield is the return youget on the money you've invested. However,there are many different ways to calculateyield, particularly with bonds. Consideringyield can be a good way to compareinvestments, as long as you know what yieldsyou're comparing and why.

Coupon rate

People sometimes confuse a bond's yield withits coupon rate (the interest rate that'sspecified in the bond agreement). A bond'scoupon rate represents the amount of interestyou earn annually, expressed as a percentageof its face (par) value. If a $1,000 bond'scoupon rate pays $50 a year in interest, itscoupon rate would be 5%.

The coupon rate is typically fixed. Though itdoes represent what a bond pays, it's not thebest measure of the return you're getting onthat investment.

Current yield

A bond's current yield represents its annualinterest payments as a percentage of thebond's market value, which may be higher orlower than par. As a bond's price goes up anddown in response to what's happening in themarketplace, its current yield will vary also.For example, if you bought a $1,000 bond witha 5% coupon rate for $900 on the openmarket, its current yield would be 5.55% (the$50 annual interest divided by the $900purchase price). If you bought the same$1,000 bond for $1,200, the current yieldwould be 4.16% ($50 divided by $1,200).

If you buy a bond at par and hold it to maturity,the current yield and the coupon rate would bethe same. However, for a bond sold at apremium or a discount to its face value, theyield and the coupon rate are different.

If you are concerned only with the amount ofcurrent income a bond can provide each year,then calculating the current yield may give youenough information to decide whether youshould purchase that bond. However, if youare interested in a bond's performance as aninvestment over a period of years, or you wantto compare it to another bond or otherincome-producing investment, the currentyield will not give you enough information. Inthat case, yield to maturity will be more useful.

Watching the Yield CurveBond maturities and their yields are related.Typically, bonds with longer maturities payhigher yields. Why? Because the longer abondholder must wait for the bond's principalto be repaid, the greater the risk compared toan identical bond with a shorter maturity, andthe more return investors demand.

If you were to draw a line on a chart thatcompares the yields of, for example, Treasurysecurities with various maturities, you wouldtypically see a line that slopes upward asmaturities lengthen and yields increase. Thegreater the difference between the yields onT-bills and 30-year bonds, the steeper thatslope. A steep yield curve often occursbecause investors want greater compensationfor tying up their money for longer periods andrunning the risk that inflation will cut netreturns over time. A flat yield curve means thatthere is little difference between short andlong maturities.

However, sometimes the yield curve canactually become inverted; in this case,short-term interest rates are higher thanlong-term rates. For example, in 2004 theFederal Reserve Board began increasingshort-term rates, but long-term rates didn't riseas quickly. A yield curve that stays inverted fora period of time is believed to indicate arecession may be about to occur.

All investing involves risk,including the potential lossof principal, and there is noguarantee that a bond willbe worth what you paid forit when you sell. Specificrisks associated with bondsinclude interest rate risk(potential loss of value froma rise in interest rates),inflation risk (decline in thepurchasing power of abond's interest payments),liquidity risk (difficultyselling a bond), and defaultrisk (if the issuer defaultson payments or repaymentof principal).

One of the most widely usedyield curves is that forTreasury securities. Theyhave virtually no credit riskbecause they are backed bythe full faith and credit ofthe U.S. government as tothe timely payment ofprincipal and interest.

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A Sample Treasury Yield Curve

Yield to Maturity, Yield to Call

Yield to maturity

Yield to maturity (YTM) reflects the rate ofreturn on a bond at any given time (assumingit is held until its maturity date). It takes intoaccount not only the bond's interest rate,principal, time to maturity, and purchase price,but also the value of its interest payments asyou receive them over the life of the bond.Yield to maturity includes the additionalinterest you could earn by reinvesting all of thebond's interest payments at the yield it wasearning when you bought it.

If you buy a bond at a discount to its facevalue, its yield to maturity will be higher thanits current yield. Why? Because in addition toreceiving interest, you would be able toredeem the bond for more than you paid for it.The reverse is true if you buy a bond at apremium (more than its face value). Its valueat maturity would be less than you paid for it,which would affect your yield.

Example: If you paid $960 for a $1,000 bondand held it to maturity, you would receive thefull $1,000 principal. The $40 differencebetween the purchase price and the facevalue is profit, and is included in thecalculation of the bond's yield to maturity.Conversely, if you bought the bond at a $40premium, meaning you paid $1,040 for it, thatpremium would reduce the bond's yieldbecause the bond would be redeemed for $40less than the purchase price.

Why is yield to maturityimportant?

Yield to maturity lets you accurately comparebonds with different maturities and couponrates. It's particularly helpful when you arecomparing older bonds being sold in thesecondary market that are priced at a discountor at a premium rather than face value. It'salso especially important when looking at azero-coupon bond, which typically sells at adeep discount to its face value but makes noperiodic interest payments. Because youreceive all of a zero's return at maturity, whenits principal is repaid, any yield quoted for azero-coupon bond is always a yield tomaturity.

Note: The value of zero coupon bonds issubject to market fluctuation. Because thesebonds do not pay interest until maturity, theirprices tend to be more volatile than bonds thatpay interest regularly. Interest income issubject to ordinary income tax each year,even though the investor does not receive anyincome payments.

Yield to call

When it comes to helping you estimate yourreturn on a callable bond (one whose issuercan choose to repay the principal beforematurity), yield to maturity has a flaw. If thebond is called, the interest payments will cometo an end. That reduces its overall yield to theinvestor. Therefore, for a callable bond, youalso need to know what the yield would be ifthe bond were called at the earliest date

Important facts about yieldto maturity

If you sell a bond before itmatures, your effective yieldcould be different from its yieldto maturity. The yield tomaturity calculation assumesyou reinvest the couponpayments at that same yieldrate. If you spend thoseinterest payments, or if interestrates fall, you wouldn't be ableto get the same yield when youreinvest your interestpayments. That would meanyour actual yield could be lessthan the yield to maturitypercentage.

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allowed by the bond agreement. That figure isknown as its yield to call; the calculation is thesame as with yield to maturity, except that thefirst call date is substituted for the maturitydate.

A bond issuer will generally call a bond only ifit's profitable for the issuer to do so. Forexample, if interest rates fall below a bond'scoupon rate, the issuer is likely to recall thebond and borrow money at the newer, lowerrate, much as you might refinance yourmortgage if interest rates drop. The less timeuntil the first date the bond can be called, andthe lower that current interest rates are whencompared to the coupon rate, the moreimportant the yield-to-call figure becomes.

Why is yield to call important?

If you rely on the income from a callablebond--for example, if it helps pay livingexpenses--yield to call is especially significant.If the bond is called at a time when interestrates are lower than when you purchased it,that reinvested principal might not provide thesame amount of ongoing income. Why?Because you would likely have difficultygetting the same return when you reinvestunless you took on more risk.

Comparing Taxable and Tax-Free Yields

$5,000 taxable bond paying 5% interest $5,000municipalpaying 3.5%

Federal tax bracket

24% 32% 35% 37%

Annualinterest

$250 $250 $250 $250 $175

Paid in taxes $60 $80 $87.50 $92.50 $0

Net income $190 $170 $162.50 $157.50 $175

Note: This hypothetical example is intended only as an illustration and does not reflect the returnof any specific portfolio.

It's important to consider a bond's after-taxyield--the rate of return earned after taking intoaccount taxes (if any) on income receivedfrom the bond. Some bonds--for example,municipal bonds ("munis") and U.S. Treasurybonds--may be tax exempt at the federaland/or the state level. However, most bondsare taxable.

Consider what you keep

A tax-exempt bond often pays a lower interestrate than an equivalent taxable bond, but mayactually have a higher yield once the impact oftaxes has been factored in. Whether this istrue in your case depends on your tax bracket.It also can be affected by whether you mustpay not only federal but state and local taxesas well.

For example, let's say you consider investingin either Bond A, a tax-exempt bond paying4% interest, or Bond B, a taxable bond paying6% interest. You want to find out whetherBond A or Bond B would be a betterinvestment in terms of after-tax yield. For

purposes of this illustration, let's also say youare in the 35% federal tax bracket and do nothave to pay state taxes.

You determine that Bond A's after-tax yield is4% (the same as its pretax yield, of course).However, Bond B's yield is only 3.8% oncetaxes have been deducted.

You'd probably decide that tax-exempt Bond Awould be better because of its higher after-taxyield.

The impact of being taxfree

In order to attract investors, taxable bondstypically pay a higher interest rate thantax-exempt bonds. Why? The associated taxexemption effectively increases the after-taxvalue of a tax-free bond's yield. That taxadvantage can mean a difference of severalpercentage points between a corporate bond'scoupon rate--the annual percentage rate itpays bondholders--and that of a muni with anidentical maturity period.

Comparing bond anddividend yields

When considering sources ofinvestment income, you cancompare a bond's yield to astock's dividend yield. Becauseit's calculated by dividing astock's annual dividendpayments by the stock's price,dividend yield will rise when thestock's price falls, and viceversa (assuming the dividendstays the same).Note that theamount of a company'sdividend can fluctuate withearnings, which are influencedby economic, market, andpolitical events. Dividends aretypically not guaranteed andcould be changed oreliminated.

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Still, as the earlier example demonstrates, atax-free bond could actually provide a betterafter-tax return. Generally, the higher your taxbracket, the higher the tax-equivalent yield ofa muni bond will be for you.

Comparing apples to oranges

To make sure you're not comparing apples tooranges, you can apply a simple formula thatinvolves your federal marginal tax rate (theincome tax rate you pay on the last dollar ofyour yearly income). The formula depends onwhether you want to know the taxableequivalent of a tax-free bond, or the tax-freeequivalent of a taxable bond. Calculating thetaxable equivalent of a tax-free bond requires

If a taxable bond also is subject to state andlocal taxes and the tax-exempt isn't, thetax-equivalent yield on the tax-free bond couldbe even lower and still come out ahead.

A financial professional can help you comparetaxable and tax-free bonds, and evaluate howto maximize the benefits of both. However,there is no assurance that working with afinancial professional will improve investmentresults.

subtracting your marginal tax rate from 1, thendividing the tax-free bond's annual yield by theresult. To calculate the tax-free equivalent of ataxable bond, you subtract your tax rate from1, then multiply it by the taxable bond's yield.

What's Taxable, What's NotComparing taxable and tax-free yieldsinvolves making sure you understand a bond'stax status. The interest on corporate bonds istaxable by local, state, and federalgovernments. However, interest on bondsissued by state and localgovernments--generically called municipalbonds, or munis--generally is exempt fromfederal income tax. If you live in the state inwhich a specific muni is issued, it may also betax free at the state or local level.

Unlike munis, the income from Treasurysecurities, which are issued by the U.S.government, is exempt from state and localtaxes but not from federal taxes. The generalprinciple is that federal and state/localgovernments can impose taxes on their ownlevel, but not at the other level; for example,states can tax securities of other states but notthose of the federal government, and viceversa.

As is true of almost anything that's tax-related,munis can get complicated. A bond'stax-exempt status applies only to the interestpaid on the bond; capital gains realized fromany increases in the bond's value are taxablewhen the bond is sold.

When are munis taxable?

Specific muni issues may be subject to federalincome tax, depending on how the bondissuer will use the proceeds. If a bondfinances a project that offers a substantialbenefit to private interests, it is taxable at thefederal level unless specifically exempted. Forexample, even though a new football stadiummay serve a public purpose locally, it willprovide little benefit to federal taxpayers. As aresult, a muni bond that finances it is

considered a so-called private-purpose bond.

Also known as private activity bonds, taxablemunis are those in which 10% or more of thebond's benefit goes to private activities, or 5%of the proceeds (or $5 million if less) are usedfor loans to parties other than governmentunits. Other public projects whose bonds maybe federally taxable include housing, studentloans, industrial development, and airports.

Even though such bonds are subject to federaltax, they still can have some advantages. Forexample, they may be exempt from state orlocal taxes. And you may find that yields onsuch taxable municipal bonds are closer tothose of corporate bonds than they are totax-free bonds.

Agencies and GSEs (government-sponsoredenterprises) vary in their tax status. Interestpaid by Ginnie Mae, Fannie Mae, and FreddieMac bonds is fully taxable at federal, state,and local levels. The bonds of other GSEs,such as the Federal Farm Credit Banks,Federal Home Loan Banks and the ResolutionFunding Corp. (REFCO), are subject tofederal tax but exempt from state and localtaxes. Before buying an agency bond, verifyits tax status.

Don't forget the AMT

To further complicate matters, interest fromprivate-purpose bonds may be specificallyexempted from regular federal income tax, butstill may be a factor in determining whetherthe alternative minimum tax (AMT) applies toyou. Even if you are not subject to the AMTwhen you purchase a bond, more people arefeeling its impact each year, and the interestfrom a private-purpose bond could change

Exempt from federal taxes

• State and local governmentbonds

Exempt from state taxes

• U.S. Treasury securities

• Somegovernment-sponsoredenterprise (GSE) bonds

Not taxexempt

• Government NationalMortgage Association(GNMA), Federal NationalMortgage Association(FNMA), and Federal HomeLoan Mortgage Corporation(FHLMC)

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your status. A tax professional can evaluate abond's potential impact on your AMT liability.

Pay attention to muni bondfunds

Just because you've invested in a municipalbond fund doesn't mean the income youreceive is automatically tax free. Some fundsinvest in both public-purpose andprivate-purpose munis and must disclose ontheir yearly 1099 forms how much of thetax-free interest they pay is subject to AMT. Ifyou own a muni bond fund, review thisinformation periodically, especially if you thinkyou might be subject to the AMT. Note: Beforeinvesting in a mutual fund, carefully compareits investment objectives, risks, fees, andexpenses, which can be found in theprospectus available from the fund. Read the

Use a tax advantage where itcounts

Be careful not to make a mistake that iscommon among people who invest through atax-deferred account, such as an IRA.Because those accounts automatically providea tax advantage, you receive no additionalbenefit by investing in tax-free bonds withinthem. By doing so, you may be needlesslyforgoing a higher yield from a taxable bond.Tax-free bonds are best held in taxableaccounts.

prospectus carefully before investing. A bondfund is subject to the same inflation,interest-rate, and credit risks association withits underlying bonds. As interest rates rise,bond prices typically fall, which can adverselyaffect a bond fund's performance.

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Nicholson Financial Services,Inc.

David S. NicholsonFinancial Advisor89 Access Road

Ste. CNorwood, MA 02062

781-255-1101866-668-1101

david@nicholsonfs.comwww.nicholsonfs.com

June 11, 2020Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2020

Securities offered through Raymond James Financial Services, Inc. Member FINRA/SIPC. NicholsonFinancial Services, Inc. is not a registered broker/dealer, and is independent of Raymond James FinancialServices. Investment Advisory Services are offered through Raymond James Financial Services Advisors,Inc.

This information, developed by an independent third party, has been obtained from sources considered tobe reliable, but Raymond James Financial Services, Inc. does not guarantee that the foregoing material isaccurate or complete. This information is not a complete summary or statement of all available datanecessary for making an investment decision and does not constitute a recommendation. The informationcontained in this report does not purport to be a complete description of the securities, markets, ordevelopments referred to in this material. This information is not intended as a solicitation or an offer to buyor sell any security referred to herein. Investments mentioned may not be suitable for all investors. Thematerial is general in nature. Past performance may not be indicative of future results. Raymond JamesFinancial Services, Inc. does not provide advice on tax, legal or mortgage issues. These matters should bediscussed with the appropriate professional.

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