Tax-Equivalent Yield

Tax-Equivalent Yield refers to the yield on a taxable investment that would be required to match the yield of a tax-exempt investment, after accounting for the investor’s tax rate. This measure helps investors compare the Returns of taxable and tax-exempt Securities.

The formula for calculating Tax-Equivalent Yield is:

Tax-Equivalent Yield = Tax-Exempt Yield / (1 – Tax Rate)

Example 1: If a municipal bond offers a yield of 4% and the investor’s tax rate is 25%, the tax-equivalent yield would be:

Tax-Equivalent Yield = 4% / (1 – 0.25) = 4% / 0.75 = 5.33%

Example 2: For a tax-exempt bond yielding 3% and an investor in the 35% tax bracket, the tax-equivalent yield is:

Tax-Equivalent Yield = 3% / (1 – 0.35) = 3% / 0.65 = 4.62%

Case: An investor considering whether to invest in a corporate bond with a 6% yield or a municipal bond yielding 4%. If their tax rate is 30%, the tax-equivalent yield of the municipal bond would be:

Tax-Equivalent Yield = 4% / (1 – 0.30) = 4% / 0.70 = 5.71%

In this case, the corporate bond would provide a higher yield (6%) compared to the tax-equivalent yield of the municipal bond (5.71%), making the corporate bond the better choice for this investor.