Lesson

Tax-equivalent yield is a concept used to compare the after-tax yield of taxable and tax-exempt fixed-income securities. It is particularly relevant for investors in high tax brackets who may benefit more from tax-exempt securities. The tax-equivalent yield is calculated by dividing the tax-exempt yield by (1 - investor's marginal tax rate).

Practice Question #1

How is the tax-equivalent yield calculated?

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Terms

Tax-equivalent yield:
A measure that compares the after-tax yield of taxable and tax-exempt fixed-income securities.
Tax-exempt yield:
The yield on a fixed-income security that is not subject to federal income tax.

Practice Question #2

Which type of fixed income security typically has a tax-exempt yield?

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Do Not Confuse With

After-tax yield:
The return on an investment after accounting for taxes.

Practice Question #3

An investor in the 28% tax bracket is considering a tax-exempt bond with a yield of 3.5% and a taxable bond with a yield of 5%. What is the tax-equivalent yield of the tax-exempt bond?

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Historical Example

In the early 1980s, interest rates were historically high, and many investors sought tax-exempt municipal bonds to maximize their after-tax income. Newspapers reported that the tax-equivalent yield of municipal bonds was often higher than taxable bonds, making them an attractive investment for high-income investors.

Practice Question #4

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Real-World Example

An investor in the 35% tax bracket is considering two bonds: a tax-exempt municipal bond with a yield of 4% and a taxable corporate bond with a yield of 6%. To compare the two, the investor calculates the tax-equivalent yield of the municipal bond: 4% / (1 - 0.35) = 6.15%. In this case, the municipal bond has a higher tax-equivalent yield, making it a more attractive investment for this investor.

Practice Question #5

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Rhyme

To compare bonds with ease, just use tax-equivalent yields, please. Divide tax-exempt by one minus your rate, and you'll find the best bond to allocate.

Practice Question #6

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Formulas to Remember

Tax-Equivalent Yield (TEY) = Yield / (1 - Investor's Marginal Tax Rate)

Practice Question #7

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Formula Examples

Suppose an investor has a marginal tax rate of 30% and is considering investing in a municipal bond with a yield of 4%. To calculate the tax-equivalent yield: TEY = Municipal Bond Yield / (1 - Investor's Marginal Tax Rate) TEY = 4% / (1 - 0.30) TEY = 4% / 0.70 TEY = 5.71% The tax-equivalent yield for this municipal bond is 5.71%.

Practice Question #8

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Pitfalls to Remember

- *Different Tax Rates*:
The formula assumes a constant marginal tax rate for the investor. If the investor's tax rate changes, the tax-equivalent yield will also change.
- *State and Local Taxes*:
The formula does not account for state and local taxes, which may also affect the tax-equivalent yield.

Practice Question #9

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