Definition
Equivalent Taxable Yield is a measure that compares the taxable yield on a corporate bond to the tax-free yield on a municipal bond. Investors use this comparison to determine which investment provides a better return after accounting for taxes. For instance, an investor in a higher tax bracket might realize a better after-tax return with a tax-exempt municipal bond versus a taxable corporate bond that offers a higher interest rate.
Examples
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Example 1: An investor in a 33% tax bracket is considering a municipal bond, which yields 4%, and a corporate bond, which yields 6%. The equivalent taxable yield formula is used to determine which option provides a better after-tax return.
\[ \text{Equivalent Taxable Yield} = \frac{\text{Tax-Free Yield}}{1 - \text{Tax Rate}} \]
Using the formula:
\[ \text{Equivalent Taxable Yield} = \frac{4%}{1 - 0.33} \approx 5.97% \]
Since 6% (corporate bond yield) is close to the equivalent taxable yield of 5.97%, the investor might lean towards the corporate bond for just slightly better nominal returns or weigh other considerations such as risk.
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Example 2: An investor in a 25% tax bracket is considering a municipal bond offering 3% and a corporate bond offering 5%. Using the equivalent taxable yield formula:
\[ \text{Equivalent Taxable Yield} = \frac{3%}{1 - 0.25} = 4% \]
The 5% yield on the corporate bond is higher than the equivalent taxable yield for the municipal bond, indicating that the corporate bond might offer a better after-tax return.
Frequently Asked Questions
What Is the Equivalent Taxable Yield Formula?
The formula to calculate the equivalent taxable yield is:
\[ \text{Equivalent Taxable Yield} = \frac{\text{Tax-Free Yield}}{1 - \text{Tax Rate}} \]
Why is Equivalent Taxable Yield Important?
Equivalent taxable yield helps investors in different tax brackets compare the returns on taxable vs. tax-exempt investments to make more informed decisions.
How Does Tax Bracket Affect Equivalent Taxable Yield?
Higher tax brackets increase the equivalent taxable yield, making tax-exempt investments more attractive relative to taxable ones.
What Is Better: Municipal Bonds or Corporate Bonds?
It depends on the investor’s tax bracket and the yields offered. Higher tax brackets often make municipal bonds more appealing due to their tax-exempt status.
Can Equivalent Taxable Yield Change Over Time?
Yes, changes in tax laws, individual earnings, or bond yields can affect the equivalent taxable yield.
Related Terms
- Municipal Bonds: Debt securities issued by states, cities, and other governmental entities to fund public projects. Their interest is often exempt from federal income tax.
- Corporate Bonds: Debt securities issued by corporations to raise capital, typically taxable at both federal and state levels.
- Tax Bracket: A range of incomes taxed at a specific rate, affecting the total tax an individual or corporation pays.
- After-Tax Return: The profit from an investment after taxes have been deducted.
Online References
- Investopedia: Equivalent Taxable Yield
- IRS: Tax-Exempt Interest
- Municipal Securities Rulemaking Board
Suggested Books
- “The Bond Book: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More” by Annette Thau
- “Bond Investing For Dummies” by Russell Wild
- “The Handbook of Municipal Bonds” edited by Sylvan G. Feldstein and Frank J. Fabozzi
- “Bonds: The Unbeaten Path to Secure Investment Growth” by Hildy Richelson and Stan Richelson
Fundamentals of Equivalent Taxable Yield: Investment Basics Quiz
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