Tax equivalent yield

Tax equivalent yield
See also
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

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.

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.

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:

$Tax\ equivalent\ yield\ =\ Tax\ free\ yield\ \cdot \ (100\%\ -\ investor's\ tax\ bracket)$

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.

$Tax\ equivalent\ yield\ =\ {\frac {7\%}{(100\%\ -\ 30\%)}}=\ {\frac {7\%}{0.7}}\ =\ 10\%$

In this example:

• 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."

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