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Equivalent Taxable Yield

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The equivalent taxable yield is used by investors to compare the yield of a taxable bond (i.e. government bond or corporate bond) with that of a tax-free bond (i.e. municipal bond). When computing the equivalent taxable yield, an investor wants to determine the minimum yield required in order to receive the same return with both instruments. The equivalent taxable yield takes into account local, state, and federal taxes that must be paid. The formula to calculate the equivalent taxable yield is:

Equivalent Taxable Yield = Tax-Free Bond Yield / (1 - Investor's Tax Rate)

In the calculation of the equivalent taxable yield, the investor's income tax rate is the sum of the marginal federal tax rate and effective state tax rate (i.e. state and local if applicable). Based on the above formula, it is evident that the equivalent taxable yield increases with the investor's marginal tax rate. Therefore, an investor in a higher tax bracket will calculate a higher equivalent taxable yield making tax-free bonds more valuable. Likewise, an investor living in a state with higher state/local taxes will compute a higher equivalent taxable yield and may too find tax-free bonds more valuable. Below is an equivalent taxable yield calculation example:

Tax-Free Bond Rate: 5%
Federal Marginal Bracket: 28%
Effective State Tax Rate: 9.3%
Local Tax Rate: 0%

Equivalent Taxable Yield = 5% /[1-(28%+(9.3%*(1-28%))]
Equivalent Taxable Yield = 7.66%

Based on this equivalent taxable yield and assuming similar credit risk, a taxable bond would need to yield more than 7.66% or more to provide a better return than a tax-free bond yielding 5%. The equivalent taxable yield is also called the taxable equivalent yield (i.e. TEY).



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