Advantages & Disadvantages of Taxes & Corporate Bonds
The tax advantages and disadvantages of corporate bonds involve different issues for the investor and the borrower. Corporate bonds are subject to both state and federal tax. Corporate bonds, for investors, must be measured for their after-tax yield. Corporate bond yields must be higher in yield than both municipal tax-exempt bonds and United States Treasury bonds, both of which receive beneficial tax treatment.
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Corporate Bonds Are Subject to Federal and State Taxes
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Corporate bond income is subject to two kinds of taxes. The first is the capital gains tax for bonds purchased at a discount or a premium from par. The discount bond has a bond purchase price below the redemption price of par, or 100, at maturity. The bondholder must pay taxes each year on the amortization, or rise in price value, as the bond approaches par. Premium bonds discount the amount of premium each year as the bond declines to par.
Interest Income From Corporate Bonds
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Income from the semiannual coupon payments of interest must be reported by individuals and institutions. The interest income isn't considered capital gains ordinary income: It's taxed at the bondholder's income tax rate. Thus, bondholders in lower tax brackets keep more of the corporate bond income. Bondholders, both individuals and institutions, owning bonds in tax-exempt or tax-deferred accounts, pay no taxes until the account is redeemed.
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Corporate Advantages of Bond Issues
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The corporate issuer has distinct advantages of issuing debt. The primary issue is that the funds raised through debt don't create additional shares of stock, or stock dilution. This would lower earnings per share and thus stock values. The issuer's debt-versus-equity decision is affected by the fact that the interest on the debt issue is tax-deductible from income. If the bond issuance adds to company profits, then earnings per share rise at a relatively low cost of capital. However, the company is more heavily leveraged and carries greater credit risk until the debt is repaid.
Interest Rate Fluctuations Affect Bond Prices
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Nearly all corporate bond issuers and buyers must concern themselves with the effect of call, or extraordinary redemption features. Corporate bond issuers usually reserve the right to redeem bonds at a slight premium before maturity at the issuer's option. The premium is a deduction for the issuer and a capital gain for the borrower. However, early call redemption means the lender loses the outstanding bond and interest income stream. If this happens during a period of low interest rates, the borrower is forced to reinvest at lower interest rates.
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