Fixed Income Investments - After Tax Yield of a Taxable Security

The after-tax yield is the yield on a taxable bond after federal income taxes are paid. It is computed with the following formula.

Formula 14.5

After-tax yield = pre-tax yield x (1- marginal rate)

The marginal rate will vary depending on the tax bracket the investor is at that given time.

Example: Taxable Bond Yield
Taxable bond yield is 7.5%
The Marginal tax rate for this investor is 31%

Answer:
After-tax yield = .075 x (1-.31)
= .05175
= 5.175%

Tax-Equivalent Yield
The tax-equivalent yield is the yield that must be offered on a taxable bond issue to give the same after-tax yield as a tax-exempt issue. It is computed with the following formula.

Formula 14.6

Taxable-equivalent yield = tax-exempt yield / (1- marginal tax rate)

Example: Tax-Exempt Yield
Tax exempt yield = 5.00%
Marginal Tax Rate = 31%

Answer:
Taxable-equivalent yield = .05 / (1-.31)
= .05 / .69
= .072464
= 7.2464 %

This means that a taxable issue must yield more than 7.25 % for the investor at the 31% tax bracket in order to beat the 5% yield offer in the tax-exempt bond.


Look Out!

Notice that the higher the marginal tax rate, the higher the taxable equivalent yield would be needed in the taxable bond market.

London Interbank Offer Rate (LIBOR)


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