Yield Equivalence
Candlefocus EditorIn essence, yield equivalence enables municipal bond investors to understand if the tax savings of their bonds will offset the lower yields relative to similar duration taxable securities. To calculate the yield equivalence between a tax-free and comparable taxable investments, investors must consider the equivalent pretax interest rate they would need to earn on a taxable security to receive the same after-tax yield as the tax-exempt investment. This calculation takes into account the current tax rates as well as the anticipated tax free rate.
In order to compare the yields of a tax-exempt versus a taxable bond, investors have to calculate the yield equivalence between the two. The calculation is done by taking the yield of the tax-exempt bond and dividing it by 1 minus the investor’s total marginal tax rate. This yield equivalence helps investors to understand the equivalent pretax interest rate they would need to earn on a taxable security to achieve the same after-tax yield as the tax-exempt investment.
For example, assume an investor in the 28% federal tax bracket and 6% state tax bracket who is considering a municipal bond that yields 2.50%. To calculate the yield equivalence on a taxable bond, the investor would divide the tax-free yield of 2.50% by the difference between 1 and their total marginal tax rate of 34%:
2.50% ÷ (1-0.34) = 3.78%
This means that if the investor purchased a taxable bond of similar duration and quality, they would need to earn a pretax yield of 3.78% to achieve the same after-tax yield as the municipal bond. Investors must also consider that municipal bonds have the benefit of continuing tax-free earnings, while taxable bonds generally do not have this feature, making municipal bonds even more attractive.
Yield equivalence is an important concept for investors in municipal bonds and other tax-exempt securities, allowing them to identify the equivalent pretax interest rate on a taxable security that would produce the same after-tax yield, and thus the same amount of return, as the municipal bond.