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 Takeaways

  • 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.
  • Yield equivalence is important to municipal bond investors, who want to know if the tax savings of their bonds will make up for the lower yields relative to similar duration taxable securities.
  • When calculating the yield equivalence between tax-free and taxable investments, investors should be aware of the current tax rates.

Understanding Yield Equivalence

Yield equivalence is important to municipal bond investors, who want to know if the tax savings of their bonds will make up for the lower yields relative to similar duration taxable securities. Yield equivalence is a comparison often used by investors when they are attempting to figure out if they’d get a better return from a tax-exempt or tax-free investment than they would from a taxable alternative.

Yield equivalence can be calculated using the following equations:

Taxable Yield Equivalence=Tax-Exempt Yield1Tax Rate\begin{aligned} &\text{Taxable Yield Equivalence} = \frac { \text{Tax-Exempt Yield} }{ 1 - \text{Tax Rate} } \\ \end{aligned}Taxable Yield Equivalence=1Tax RateTax-Exempt Yield

and

Tax-Exempt Yield Equivalence= Taxable Yield ×(1Tax Rate)\begin{aligned} \text{Tax-Exempt Yield Equivalence} =& \ \text{Taxable Yield} \ \times \\ &( 1 - \text{Tax Rate} ) \\ \end{aligned}Tax-Exempt Yield Equivalence= Taxable Yield ×(1Tax Rate)

To calculate the yield equivalence between tax-exempt and taxable securities, start by dividing the bond’s tax-exempt yield by 1 minus the investor's tax rate. For example, suppose you were considering an investment in a 6% tax-exempt municipal bond, but wanted to know what the interest rate on a taxable corporate bond would have to be to give you the same return. If you have a 24% rate of taxation, you would subtract 0.24 minus one, which totals .76. Then, you would divide 6, the tax-exempt yield, by .76, which equals 7.9.

This calculation tells you that you would need a return of 7.9% on your taxable investment to match the 6% return on the tax-exempt investment. If, on the other hand, you were in the 35% tax bracket, you would need a return of 9.2% on your corporate bond to match the 6% return on your muni investment.

Conversely, if you know your taxable rate of return, you can calculate the equivalent rate on a tax-exempt investment. This is done by multiplying the taxable rate by 1 minus your tax rate. So, if your taxable return is 6% and your rate of taxation is 24%, you need a 4.6% return on a tax-exempt security to match the after-tax return on a taxable security.

New Marginal Tax Rates

The passage of the Tax Cuts and Jobs Act in late 2017 resulted in a number of changes to marginal tax rates and income brackets beginning in 2018. The marginal tax rate is the rate of tax income earners incur on each additional dollar of income. As the marginal tax rate increases, taxpayers end up with less money per dollar earned than they had retained on previously earned dollars.

Tax systems employing marginal tax rates apply different tax rates to different levels of income; as income rises, it is taxed at a higher rate. It is important to note, however, the income is not all taxed at one rate but at many rates as it moves across the marginal tax rate schedule.

When calculating the yield equivalence between tax-free and taxable investments, investors should be aware of these new tax rates and incorporate them accordingly into their yield equivalence equations.

2021 Income Tax Brackets

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