Taxable Equivalent Yield
What It Is:
Taxable equivalent yield (also called equivalent taxable interest rate) is the return that is required on a taxable investment to make it equal to the return on a tax-exempt investment. The taxable equivalent yield is commonly used when evaluating municipal bond returns.
How It Works/Example:
The formula for taxable equivalent yield is:
R(te) = R(tf)/(1- t)
R(te) = taxable equivalent yield for the investor
t = investor's marginal tax rate
For example, let's assume Investor A, who is in a 28% tax bracket, is considering whether to invest in a municipal bond with a 10% interest rate. Using the formula above, we can calculate that, for this investor, the municipal bond's taxable equivalent yield is:
R(te) = 0.10 / (1 - 0.28)
Therefore, a taxable bond would have to yield greater than 13.89% to become more profitable to this investor than the municipal bond.
The tax-free advantage of municipal bonds can make a tremendous difference in an investor's overall returns, especially if the investor is in a high tax bracket. For example, let's assume another investor, Investor B, only has a marginal tax rate of 20% and is considering whether to invest in that same 10% municipal bond. Using the formula above, we can calculate that Investor B's taxable equivalent yield for the same bond is:
R(te) = 0.10 / (1 - 0.20)
R(te) = 0.125 = 12.5%
For Investor A, a taxable bond would have to return more than +13.89% to become more favorable than the 10% municipal bond. But because Investor B is in a lower tax bracket, he/she would only have to earn more than +12.5% from the taxable bond to become more favorable than the same 10% municipal bond.
Why It Matters:
Municipal bonds usually offer lower returns than similar taxable corporate bonds. But how does the investor know if the tax savings from the municipal bond will make up for its lower return? The taxable equivalent yield helps decide, because it facilitates apples-to-apples comparisons among securities with different tax consequences.