Tax-Equivalent Yield
Candlefocus EditorTax-equivalent yield calculation is used to adjust the yield of a tax-exempt bond to account for the fact that the interest earned will not be subject to tax. The adjusted yield is then compared to the yield of a similar taxable bond to determine the relative attractiveness of each investment. The calculation allows investors to determine the true value of the benefits of investing in a tax-exempt bond.
To calculate a tax-equivalent yield, an investor needs to know the yield on a comparable taxable bond as well as the investor's tax rate. Once these values are known, the tax equivalent yield can be calculated by dividing the yield on the taxable bond by one minus the investor's tax rate.
For example, if an investor has a tax rate of 25%, the tax equivalent yield is calculated by taking the yield of a comparable taxable bond and dividing it by 0.75 (1-0.25). If the yield on the taxable bond is 3%, the tax-equivalent yield would be 4%.
The tax-equivalent yield calculation is useful for investors who are considering a tax-exempt bond but want to ensure they are getting the best potential return on their investment. The calculation allows investors to make an informed decision by ensuring they are getting a competitive return when compared to similar taxable investments. It should also be noted that the tax-equivalent yield calculation does not account for other factors that may influence an investment decision such as the risk level associated with each investment or any other fees or expenses associated with each bond.
Overall, understanding the concept of the tax-equivalent yield is an important part of any investor's financial strategy. By understanding the calculation and its implications, investors can make better decisions when considering an investment and ensure they are getting the maximum return possible on their money.