This is one of the most frequently asked questions about fixed income – 03/31/2023 – From Grain to Grain

For most, the term “fixed income” brings the image of something simple and monotonous. After all, it’s fixed income. What could you bring different from the fixed? However, as investors are introduced to the diversity of fixed income, doubts arise. Some are more frequent and today I address one of the most common.

The questions I receive the most are related to three factors: taxes, issuer and profitability. Today I’m going to talk about the first factor.

The most common tax-related question is: exempt title yields more than another taxable title?

I agree that nobody likes to pay taxes. Also, I imagine that no reader will say that they pay little tax. However, with fixed income, paying tax can be more interesting than not paying.

You have to make the account. Therefore, it is not true that tax-exempt bonds will always yield more than tax-exempt equivalents.

The account is simple, but before presenting it, I will pose a question:

Consider two investors who are going to buy a bond maturing in the period they want to invest. Investor X wants to invest for 1 year and investor Y will invest for more than 2 years, which security would present the highest return at the end of the term for each investor?
a) LCA yielding 98% of the CDI (tax free)
b) CDB yielding 116% of the CDI (taxed)

Contrary to popular belief, the answer is not the same for both investors. This occurs because each one is subject to an IR rate that varies with the time of application.

Investor X will apply for 1 year. Therefore, it is subject to an income tax rate of 17.5% on the return. Investor Y, for investing for more than 2 years, will be subject to a 15% rate.

There is a simplified way to make the account.

Simply divide the expected return on the exempted investment by the factor (1 – income tax rate). Alternatively, you can multiply the expected return on the taxed investment by the same factor as above.

Thus, for investor X, the account would be 0.98/(1-0.175). The result is equivalent to a taxed return of 118.8% of the CDI. Therefore, in the case of a one-year investment, the IR-free yield of 98% of the CDI is greater than the net IR yield of the CDB investment with a return of 116% of the CDI.

In the case of investment for more than 2 years, that is, investor Y, the result is different. The taxed income of 116% of the CDI is more advantageous than the exempt income of 98% of the CDI.

As we mentioned, the simplified account is 0.98/(1-0.15). Exempt income is equivalent to taxed income with a return of approximately 115.3% of the CDI. Therefore, the exempt investment would lose.

Therefore, for investor X, the best investment would be exempt, but for investor Y, the taxed investment is more advantageous.

Investors prefer not to pay income tax. Therefore, the preference for the exempt title is almost natural and most do not do the math.

Knowing this, banks take advantage and place exempt applications with even lower yields than their taxed equivalents. Therefore, your profit margins improve.

Don’t fall into the trap of not counting.

Remember, too, to consider the correct IR rate. If you are going to invest for more than 2 years, there is no point in investing in LCA with a yield of 96%, maturing in 6 months and making the account with the 6-month rate. What counts is the period you intend to keep the application and not the maturity time of the title.

Doing the math properly, you will earn more with each investment. I reinforce that this is a simplified account, but it already solves the basic account in a simple and quick way if it is worth applying in an investment exempt from IR in relation to another taxed person with the same risk.

Michael Viriato is an investment advisor and founding partner of Investor House.

Talk directly to me via email.

Follow and like De Grão em Grão on social networks. Follow the investment lessons in Instagram.

PRESENT LINK: Did you like this text? Subscriber can release five free hits of any link per day. Just click the blue F below.