Tax equivalent yield: Difference between revisions
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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'''<ref>R. C. Marston, 2014, p. 139</ref>. | 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'''<ref>R. C. Marston, 2014, p. 139</ref>. | ||
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'''<ref>The Securities Institute of America, 2014, p. 58</ref>. | 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'''<ref>The Securities Institute of America, 2014, p. 58</ref>. | ||
==The Tax equivalent yield Formula== | ==The Tax equivalent yield Formula== | ||
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<math> Tax\ equivalent\ yield\ =\ Tax\ free\ yield\ \cdot\ (100\%\ -\ investor's\ tax\ bracket)</math> | <math> Tax\ equivalent\ yield\ =\ Tax\ free\ yield\ \cdot\ (100\%\ -\ investor's\ tax\ bracket)</math> | ||
==Example of The Tax equivalent yield== | ==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. | 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. | ||
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* if the corporate bond yields more than 10 %, the investor will be better off with the '''corporate bond'''." | * if the corporate bond yields more than 10 %, the investor will be better off with the '''corporate bond'''." | ||
==References== | {{infobox5|list1={{i5link|a=[[Required rate of return]]}} — {{i5link|a=[[Net yield]]}} — {{i5link|a=[[Free cash flow yield]]}} — {{i5link|a=[[Net present value (NPV)]]}} — {{i5link|a=[[Market Risk Premium]]}} — {{i5link|a=[[Tax preference theory]]}} — {{i5link|a=[[Nominal rate of return]]}} — {{i5link|a=[[Dividend per share]]}} — {{i5link|a=[[Blended Rate]]}} }} | ||
==References== | |||
* Boston Institute of Finance, (2005)., [https://books.google.pl/books?id=Nl3kDoJxIskC&pg=PA69&dq=tax+equivalent+yield&hl=pl&sa=X&ved=0ahUKEwjo2oGUp4vmAhUGlIsKHWB1AQs4HhDoAQhuMAc#v=onepage&q=tax%20equivalent%20yield&f=false, ''The Boston Institute of Finance Stockbroker Course: Series 7 and 63 Test Prep''], John Wiley & Sons, United States of America | * Boston Institute of Finance, (2005)., [https://books.google.pl/books?id=Nl3kDoJxIskC&pg=PA69&dq=tax+equivalent+yield&hl=pl&sa=X&ved=0ahUKEwjo2oGUp4vmAhUGlIsKHWB1AQs4HhDoAQhuMAc#v=onepage&q=tax%20equivalent%20yield&f=false, ''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)., [https://books.google.pl/books?id=odAWAAAAQBAJ&pg=PT496&dq=tax+equivalent+yield&hl=pl&sa=X&ved=0ahUKEwjP8uTkqIvmAhUolIsKHXzABIoQ6AEIeTAI#v=onepage&q=tax%20equivalent%20yield&f=false, ''Personal Financial Planning''], Cengage Learning, United States of America | * Gitman L. J., Joehnk M. D., Billingsley R., (2013)., [https://books.google.pl/books?id=odAWAAAAQBAJ&pg=PT496&dq=tax+equivalent+yield&hl=pl&sa=X&ved=0ahUKEwjP8uTkqIvmAhUolIsKHXzABIoQ6AEIeTAI#v=onepage&q=tax%20equivalent%20yield&f=false, ''Personal Financial Planning''], Cengage Learning, United States of America | ||
Latest revision as of 05:40, 18 November 2023
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].
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]:
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.
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
Author: Aleksandra Walawska
