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).
How is the tax-equivalent yield calculated?
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Select an option above to see an explanation here.
A) The tax-equivalent yield is calculated by dividing the tax-exempt yield by (1 - investor's marginal tax rate). B) This formula would calculate the after-tax yield of a taxable bond. C) This formula would calculate the after-tax yield of a tax-exempt bond. D) This formula would calculate the pre-tax yield of a taxable bond.
Which type of fixed income security typically has a tax-exempt yield?
A) Corporate bonds typically have taxable interest. B) State and local governments issue municipal bonds and often have tax-exempt interest. C) Treasury bonds have taxable interest but are exempt from state and local taxes. D) Government-sponsored enterprises issue agency bonds and typically have taxable interest.
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?
A) The tax-equivalent yield is calculated by dividing the tax-exempt yield (3.5%) by (1 - investor's marginal tax rate (0.28)): 3.5% / (1 - 0.28) = 4.86%. B) This is not the correct calculation for the tax-equivalent yield. C) This is not the correct calculation for the tax-equivalent yield. D) This is not the correct calculation for the tax-equivalent yield.
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.
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Example Series 65 Example Practice Question
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.
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.
Tax-Equivalent Yield (TEY) = Yield / (1 - Investor's Marginal Tax Rate)
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%.