Definition
The term taxable equivalent yield refers to a calculation that converts the yield on a tax-exempt investment to that of a taxable investment. Taxable equivalent yield is frequently used when investing in municipal bonds.
Calculation
Taxable Equivalent Yield (%) = Return on Tax-Exempt Investment / (1 - Tax Rate)
Where:
Tax Rate is the investor's marginal income tax rate, which can include factors for both state and federal income taxes.
Explanation
Also known as the taxable equivalent rate, the taxable equivalent yield provides investors with a measure they can use to compare the yields on taxable and tax-exempt bonds. Since the calculation is sensitive to the investor's marginal income tax rate, two investors faced with the same choice between a taxable and tax-exempt bond can come to different conclusions as to which provides a higher after-tax return.
Since the income derived from most corporate bonds is subject to federal income tax (and oftentimes state income taxes too), the only way an investor can make a fair yield comparison to a municipal bond is to adjust the yield for income taxes. Calculating the taxable equivalent yield provides for that direct comparison.
Example
Two investors are faced with a decision between a municipal bond paying 4.00% and a corporate bond paying 5.75%. Investor A is in the 24% tax bracket, while Investor B is in the 37% tax bracket. The taxable equivalent yield for each investor is shown below:
For Investor A= 4.00 / (1 - 0.24), or 5.26%
For Investor B= 4.00 / (1 - 0.37), or 6.35%
So, while the corporate bond paying 5.75% would provide Investor A with a higher return than the municipal bond with a taxable equivalent yield of 5.26%, Investor B would realize higher returns by purchasing the municipal bond with a taxable equivalent yield of 6.35%.
Related Terms
intrinsic value, extrinsic value, current yield, coupon, yield to maturity
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