TaxableEquivalent

Taxable-equivalent yield is a measure used to compare investments with different tax treatments, particularly tax-exempt municipal bonds and taxable securities. It represents the yield a taxable investment would need to offer to produce the same after-tax return as a tax-exempt investment, given the investor’s marginal tax rate.

Calculation typically uses the formula: if y_exempt is the tax-exempt yield and t is the investor’s marginal tax rate, the taxable-equivalent yield y_te = y_exempt / (1 - t). When an investor faces both federal and state taxes, t is the combined rate; some analyses may separately account for federal and state taxes to reflect different tax environments.

Example: if a municipal bond yields 4% and an investor is in a 25% marginal tax bracket, the taxable-equivalent yield is 4% / (1 - 0.25) = 5.33%. If the same investor faced a 35% rate, the taxable-equivalent yield would be 4% / 0.65 ≈ 6.15%.

Applications of the concept include comparing the attractiveness of tax-exempt bonds to fully taxable securities, such as corporate or government bonds, to help an investor decide where to allocate funds. It is particularly relevant for individuals in higher tax brackets who benefit more from tax-exempt income.

Limitations should be noted. Taxable-equivalent yield assumes a constant marginal tax rate and does not fully capture complexities such as state taxes, the alternative minimum tax, changes in tax law, or differences in risk, liquidity, or price volatility between securities. It is a tool for comparison rather than a guarantee of after-tax returns.