Key Takeaways
- Tax-equivalent yield is a calculation investors use to compare yields on a taxable bond versus a tax-exempt bond.
- Corporate bond interest payments are taxed as income.
- Treasury securities are subject to federal income tax but exempt from state and local taxes.
- Municipal bonds usually are exempt from federal taxes.
- To calculate tax-equivalent yield, divide the yield of a tax-exempt bond by one minus the investor’s marginal tax rate.
How Does Tax-Equivalent Yield Work?
Bond investors often look at yields when they determine which bonds to purchase to maximize their returns. However, a bond’s yield is only part of the picture of its profitability. Taxation can reduce the amount of returns you take in from interest rate payments.
Some bond coupon payments are exempt from state or federal taxes, others are not. Tax-equivalent yield is a number that tells you how much a taxable bond needs to yield before taxes to provide an equal yield to a taxable bond.
Because you'll be comparing a taxed bond to a tax-exempt bond to determine tax-equivalent yield, you'll need to factor in your personal income tax bracket. Afterall, that is how to calculate how much tax you'd be responsible for with a taxable bond.
You'll want to know which government taxes a taxable bond is subject to so you can compare it to a tax-exempt bond. Interest on typically is taxed as ordinary income. However, government-issued bonds usually are exempt from some taxes. For example, interest on Treasury bills, notes, and bonds is taxable at the federal level but exempt from state and local taxes.
Note
Interest paid to municipal bond investors typically is exempt from federal taxes. It may also be exempt from state taxes if the investor lives in the state that issued the bond. That means a taxable bond needs to pay a higher pretax yield than a tax-exempt bond to provide the same yield to investors.
How To Calculate Tax-Equivalent Yield
The formula for tax-equivalent yield is the tax-free bond yield divided by one minus the investor’s marginal tax rate, or income tax bracket:
Tax-equivalent yield = Tax-free bond yield / (1 – marginal tax rate)
Example of Tax-Equivalent Yield
Suppose you’re an investor whose tax bracket is 32%. You’re comparing a tax-free municipal bond that yields 5% to a taxable corporate bond. Using the tax-equivalent yield formula, it would only make sense to invest in the corporate bond if it yields at least 7.35%.
7.35% = 5% / (1 – 0.32)
If the corporate bond only yielded 6%, you’d earn lower returns than you would have gotten from the municipal bond after accounting for taxes.
Note
Remember, you'll want to factor in your total tax rate for the taxes that apply to the bond. So if an investor is in the 32% federal tax bracket and lives in New York, where state income tax is 6.85%, then the tax rate to subtract from 1 would be 38.85%.
Do I Need Tax-Equivalent Yield?
If you’re an investor who’s comparing a taxable bond to a tax-exempt bond, you need to consider tax-equivalent yield. Using the formula will help maximize your after-tax yield.
Comparing the yields of two bonds won’t give you the full picture of which bond would be more profitable, because yield alone doesn’t account for taxes. The formula is especially important for investors with high incomes because they’ll pay higher tax rates on interest earned from corporate bonds.
What Tax-Equivalent Yield Means for Individual Investors
Taxes are an important factor in any investment decision. Individual investors should consider tax-equivalent yield to maximize their after-tax returns.
If you invest solely based on which bond pays the highest yield, you may lose a significant portion of your returns to taxes. Tax-equivalent yield helps you compare bonds to determine which is right for your tax situation.
Tax-equivalent yield will vary for individual investors based on their federal, state, and local income tax rates.
Frequently Asked Questions (FAQs)
Why is tax-equivalent yield significant?
Tax-equivalent yield is significant because it tells you the amount of interest a corporate bond must pay to provide the same after-tax yield as a tax-exempt bond. The calculation helps investors determine which bond provides the best after-tax returns.
What is the formula for tax-equivalent yield?
The formula for tax-equivalent yield is the yield of a tax-exempt bond divided by one minus the investor’s marginal tax rate, or: Tax-free bond yield / (1 – marginal tax rate) = Tax-equivalent yield.
As a financial expert with a deep understanding of investment strategies and taxation, let's delve into the key concepts presented in the article on tax-equivalent yield:
1. Taxation Impact on Bond Yields:
The article emphasizes the impact of taxation on bond yields. It distinguishes between taxable and tax-exempt bonds, highlighting that corporate bond interest payments are taxed as income, while Treasury securities are subject to federal income tax but exempt from state and local taxes. Municipal bonds, on the other hand, are usually exempt from federal taxes.
2. Understanding Tax-Equivalent Yield:
- Definition: Tax-equivalent yield is a calculation used by investors to compare yields on taxable bonds to those on tax-exempt bonds.
- Purpose: It helps investors understand how much a taxable bond needs to yield before taxes to provide an equivalent return to a tax-exempt bond.
3. Factors Affecting Tax-Equivalent Yield:
- Personal Income Tax Bracket: The tax-equivalent yield formula takes into account the investor's marginal tax rate. Investors must be aware of their income tax bracket to accurately calculate the tax-equivalent yield.
4. Tax Treatment of Bond Interest:
- Taxation of Bond Interest: Interest on taxable bonds is generally taxed as ordinary income.
- Government-Issued Bonds: Government-issued bonds, such as Treasury bills, notes, and bonds, may be exempt from certain taxes, like state and local taxes.
5. Calculation of Tax-Equivalent Yield:
- Formula: Tax-equivalent yield = Tax-free bond yield / (1 – marginal tax rate)
- Example: The article provides a practical example where an investor with a 32% tax bracket would consider a taxable corporate bond only if it yields at least 7.35%, compared to a tax-free municipal bond yielding 5%.
6. Considerations for Investors:
- Importance of Tax-Equivalent Yield: Investors, especially those with higher incomes and tax brackets, are advised to consider tax-equivalent yield. It ensures a comprehensive assessment of after-tax returns when comparing different bonds.
7. Application in Investment Decisions:
- Maximizing After-Tax Returns: The article suggests that comparing yields alone may not provide a complete picture. Tax-equivalent yield helps investors make informed decisions by accounting for the impact of taxes on returns.
8. FAQs:
- Significance of Tax-Equivalent Yield: The article answers why tax-equivalent yield is significant, emphasizing its role in helping investors determine which bond provides the best after-tax returns.
- Formula Recap: The formula for tax-equivalent yield is reiterated for clarity.
Conclusion:
Understanding tax-equivalent yield is crucial for investors to make informed decisions, especially in a landscape where taxation significantly affects the overall returns on investments. By considering this metric, investors can tailor their bond portfolios to maximize after-tax yields, aligning their choices with their specific tax situations.
