Tax equivalent yield

The tax-equivalent yield is the pre-tax yield that a taxable bond must have to be equal to that of a tax-free municipal bond for its value. This equation can be used to equate a tax-free bond's yield equally with a taxable bond's yield to see which bond has a higher yield. It is also known as the yield after tax^[1].

Consideration of the tax implications of investing in municipal bonds is important for investors. Because the interest earned from municipal bonds is tax-free federally, municipal bonds will offer a lower rate than other similar quality bonds. Although the rate is often much lower, the investor may still be better off with the lower municipal rate than with a higher corporate bond rate. Investors in a higher tax bracket will benefit from the tax exemption more than investors in a lower tax bracket. To ascertain where an investor would be better off after taxes, it's good to look to the tax-equivalent yield^[2].

Contents

• 1 The Tax equivalent yield Formula
• 2 Example of The Tax equivalent yield
• 3 References
• 4 Footnotes

The Tax equivalent yield Formula

Look at the tax-equivalent yield calculated using the following formula to determine where an investor would be better off after taxes^[3]:

T a x   e q u i v a l e n t   y i e l d   =   T a x   f r e e   y i e l d   ⋅   ( 100 %   −   i n v e s t o r ′ s   t a x  

Example of The Tax equivalent yield

A good example is presented by The Securities Institute of America and it reads as follows: "Take an investor considering purchasing a municipal bond with a coupon rate of 7 %. The investor is also considering investing in a corporate bond instead. The investor is in the 30% federal tax bracket and wants to determine which bond is going to give the greatest return after taxes.

T a x   e q u i v a l e n t   y i e l d   =   7 % ( 100 %   −   30 % ) =   7 % 0.7   =   10 %

In this example^[4]:

• if the corporate bond of similar quality does not yield more than 10 %, then the investor will be better off with the municipal bond
• if the corporate bond yields more than 10 %, the investor will be better off with the corporate bond."

Tax equivalent yield — recommended articles

Required rate of return — Net yield — Free cash flow yield — Net present value (NPV) — Market Risk Premium — Tax preference theory — Nominal rate of return — Dividend per share — Blended Rate

References

• Boston Institute of Finance, (2005)., The Boston Institute of Finance Stockbroker Course: Series 7 and 63 Test Prep, John Wiley & Sons, United States of America
• Gitman L. J., Joehnk M. D., Billingsley R., (2013)., Personal Financial Planning, Cengage Learning, United States of America
• Marston R. C., (2014)., Investing for a Lifetime: Managing Wealth for the "New Normal", John Wiley & Sons, United States of America
• Richelson H., Richelson S., (2011)., Bonds: The Unbeaten Path to Secure Investment Growth, John Wiley & Sons, United States of America
• The Securities Institute of America, Inc., (2014)., Wiley Series 65 Exam Review 2015: The Uniform Investment Advisor Law Examination, John Wiley & Sons, United States of America

Footnotes

1. ↑ R. C. Marston, 2014, p. 139
2. ↑ The Securities Institute of America, 2014, p. 58
3. ↑ The Securities Institute of America, 2014, p. 58
4. ↑ The Securities Institute of America, 2014, p. 58)

Author: Aleksandra Walawska