What Is Yield Equivalence?
Yield equivalence is the interest rate on a taxable security that would generate a return equivalent to the return of a tax-exempt security, and vice versa.
Key Insights
- Yield equivalence provides investors with a way to compare the returns of taxable and tax-exempt securities.
- It is especially crucial for municipal bond investors seeking to understand if the tax savings compensate for lower yields.
- Current tax rates play a significant role in calculating yield equivalence, highlighting the importance of staying updated.
Importance to Investors
Yield equivalence offers municipal bond investors clarity on whether the tax savings from their bonds offset their generally lower yields when compared to similar-duration taxable securities. This comparison helps investors decide between tax-exempt investments and taxable alternatives.
Calculating Yield Equivalence
For effective decision-making, yield equivalence can be determined with straightforward equations:
Taxable Yield Equivalence = \frac{\text{Tax-Exempt Yield}}{1 - \text{Tax Rate}}
Example:
Imagine you are evaluating a 6% tax-exempt municipal bond but want to know the equivalent interest rate on a taxable corporate bond. If your tax rate is 24%, calculate as follows:
- Subtract 0.24 from one: 1 - 0.24 = 0.76
- Divide the tax-exempt yield by 0.76: 6 / 0.76 = 7.9%
You would need a 7.9% return on the taxable investment to match the 6% return on the tax-exempt bond. If your tax bracket is 35%, you would need a return of 9.2% to match that 6% yield.
Conversely, to determine the tax-exempt equivalent for a known taxable rate of return, use:
Tax-Exempt Yield Equivalence = \text{Taxable Yield} \times (1 - \text{Tax Rate})
If your taxable return is 6% and your tax rate is 24%, the calculation would be:
- Multiply the taxable rate by (1 - tax rate): 6% * (1 - 0.24) = 4.6%
So, a 4.6% return on a tax-exempt investment equates the after-tax return on a taxable investment.
Updated Marginal Tax Rates
The 2017 Tax Cuts and Jobs Act introduced significant changes to marginal tax rates and income brackets starting in 2018, impacting how you calculate yield equivalence. As marginal tax rates escalate, each additional dollar earned is taxed at a higher rate, reducing net income.
Here’s a snapshot of the 2021 income tax brackets to consider while calculating yield equivalence:
| Rate | Individuals | Married Filing Jointly |
|---|---|---|
| 10% | Up to $9,950 | Up to $19,900 |
| 12% | $9,951 to $40,525 | $19,901 to $81,050 |
| 22% | $40,526 to $86,375 | $81,051 to $172,750 |
| 24% | $86,376 to $164,925 | $172,751 to $329,850 |
| 32% | $164,926 to $209,425 | $329,851 to $418,850 |
| 35% | $209,426 to $523,600 | $418,851 to $628,300 |
| 37% | Over $523,600 | Over $628,300 |
When performing yield equivalence calculations, adjusting for these updated tax rates is crucial for making informed investment decisions.
Related Terms: taxable securities, tax-exempt securities, municipal bonds, interest rates, marginal tax rate.
References
- Congressional Research Service. “The Federal Income Tax: How Did P.L. 115-97 Change Marginal Income Tax Rates?”
