Tax-Equivalent Yield (TEY) is a useful calculation for investors who want to compare the yields of taxable bonds with the yields of tax-free municipal bonds. It adjusts the yield of a tax-free bond so that it can be compared on an equal basis with a taxable bond.
Calculation of Tax-Equivalent Yield
To calculate the Tax-Equivalent Yield, an investor must perform the following steps:
- Identify the investor’s Marginal Tax Bracket.
- Subtract the Marginal Tax Bracket from 100% to find the reciprocal.
- Divide the yield of the tax-free municipal bond by this reciprocal.
Formula
The formula for Tax-Equivalent Yield is as follows:
Example
Assume an investor is in the 35% marginal tax bracket and is considering a municipal bond that yields 4% annually. The calculation would be:
- Marginal Tax Rate = 35% or 0.35
- Tax Bracket Reciprocal = 1 - 0.35 = 0.65
- TEY = \( \frac{0.04}{0.65} \approx 0.0615 \) or 6.15%
This means a taxable bond would need to offer a yield of 6.15% to be equivalent to the 4% yield of the tax-free municipal bond.
Types of Bonds
Municipal Bonds
Municipal bonds are typically tax-free on the federal level and often on state and local levels, particularly if the investor resides in the state where the bond was issued.
Taxable Bonds
Taxable bonds include corporate bonds, U.S. Treasury bonds, and other fixed-income securities. The interest earned on these bonds is subject to state and federal taxes.
Applicability and Benefits
Tax-Equivalent Yield is particularly beneficial for:
- High-income investors in higher tax brackets.
- Investors comparing municipal and taxable bond securities.
- Financial planners analyzing investment strategies for clients based on differing tax scenarios.
Special Considerations
- State and Local Taxes: Some municipal bonds might also be subject to state and/or local taxes depending on the investor’s place of residence.
- Alternative Minimum Tax (AMT): Some tax-exempt bonds may still be subject to the AMT.
FAQs
Why is Tax-Equivalent Yield important?
Can TEY calculations change over time?
Is it better to invest in municipal or taxable bonds?
Historical Context
The concept of Tax-Equivalent Yield became particularly relevant after the introduction of income tax laws, which affected the after-tax return on various investments. Over time, as tax regulations evolved, calculating TEY has provided a clearer methodology for comparison between taxable and tax-free investment options.
Related Terms
- Marginal Tax Rate: The percentage of tax applied to an individual’s last dollar of income which directly influences TEY calculation.
- After-Tax Yield: The net return on an investment after accounting for taxes, crucial for investors in different tax brackets.
Summary
Tax-Equivalent Yield is a crucial measure in the domain of finance and investments, enabling investors to compare yields from tax-free municipal bonds with those from taxable bonds on a level playing field. By understanding and calculating TEY, investors can make more strategic decisions that align with their financial goals and tax situations.
References
- Investopedia. (n.d.). Tax-Equivalent Yield Definition. Retrieved from Investopedia
- NerdWallet. (n.d.). How to Calculate Tax Equivalent Yield. Retrieved from NerdWallet
Summary
Tax-Equivalent Yield is an essential concept for investors keen on making the most effective investment decisions considering tax implications. By understanding how to calculate and apply TEY, investors, especially those in higher tax brackets, can better assess the value of different bonds within their portfolios.
