What is tax equivalent yield?

Problem:

Joe has a $1000 to invest. He has two options before him:

  • (A) Invest the $1000 and buy a tax exempt municipal bond in the state he lives in with a yield of 5%
  • (B) Invest the $1000 in a corporate bond with a yield of 7%

Assume both bonds have the same risk profile and that both can be purchased at par value of $1000. He is in the 28% federal tax bracket and the state he lives in has an income tax rate of 7%. He is in a dilemma and he is asking you for guidance. What would you recommend?

 

Answer:

Correct Answer is Option (A).

 

Explanation:

Municipal bonds are exempt from federal taxes. If you purchase municipal bonds in the state you live in, there is no state income tax on the bond too. Table below shows the yield, taxes that are applied on the yields from corporate bond and the final yield Joe walks away with.

TaxEqYield_x1

You can see that Joe walks away with slightly more when he invests in a municipal bond. Generally, the higher you are in the tax bracket, the more attractive a tax free yield becomes.

Below is the formula to calculate tax equivalent yield in order for it to match the returns of a tax free yield.

Taxable Yield = Tax Free Yield / (1 – tax rate)

Taxable Yield = 5 / (1 -(0.28+0.07) = 7.69%

Joe needs to find a corporate bond that yields 7.69% in order to match the returns of a tax free municipal bond. See table below:

TaxEqYield_x2

Here is the key thing to remember: when you compare two investments that are taxed differently, always remember to look at the after tax return.

 

 

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