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Tax-Equivalent Yield: Turning a Tax-Free Yield Into a Taxable-Yield Comparison

Fixed Income Taxation Investments

Learn what tax-equivalent yield measures, how to calculate it, and why it is essential when comparing municipal bonds with taxable bonds.

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Tax-equivalent yield (TEY) is the pretax yield a taxable bond would need to offer in order to match the after-tax attractiveness of a tax-exempt bond.

It is mainly used when comparing taxable bonds with municipal bonds, whose interest may be exempt from some taxes.

Why TEY Matters

A taxable bond may show a higher headline yield than a municipal bond, but that does not mean it is the better deal after taxes.

TEY converts the tax-exempt yield into a taxable-bond equivalent so the investor can compare the two on a common basis.

Basic Formula

$$ \text{Tax-Equivalent Yield} = \frac{\text{Tax-Exempt Yield}}{1-\text{Marginal Tax Rate}} $$

The higher the investor’s tax rate, the more valuable the tax exemption becomes.

Worked Example

Suppose a municipal bond yields 4.0% and the investor’s marginal tax rate is 35%.

$$ \text{TEY} = \frac{0.04}{1-0.35} = \frac{0.04}{0.65} \approx 6.15\% $$

That means a taxable bond would need to yield about 6.15% to match the appeal of the 4.0% tax-exempt bond for that investor.

When TEY Is Most Useful

TEY is especially useful for:

  • investors in higher tax brackets
  • municipal-vs-corporate bond comparisons
  • portfolio allocation decisions in taxable accounts

It is less important in tax-sheltered accounts where tax treatment may not immediately affect the decision.

Important Caveats

The simple formula is a starting point, not the whole story.

Investors should also consider:

  • state and local tax treatment
  • whether interest is subject to alternative minimum tax rules
  • credit risk differences
  • liquidity differences
  • maturity and duration differences

A tax-free bond and a taxable bond may have very different risk profiles even if TEY makes the headline yield comparison look close.

  • Tax-Exempt Yield: The tax-free yield that TEY converts into a taxable comparison.
  • Municipal Bonds: The bond category most commonly analyzed with TEY.
  • After-Tax Yield: The yield an investor actually keeps after taxes.
  • Yield to Maturity (YTM): A broader bond-yield measure that still needs tax interpretation in taxable accounts.
  • Coupon Rate: The stated bond rate, which is not the same thing as tax-equivalent yield.

FAQs

Who benefits most from tax-equivalent yield analysis?

Usually investors in higher tax brackets, because the tax exemption is more valuable to them.

Does a higher tax-equivalent yield guarantee the better investment?

No. Credit quality, duration, liquidity, and tax details still matter.

Is the simple TEY formula always exact?

No. It is a useful shortcut, but state taxes, local taxes, and special tax rules can change the real comparison.
Revised on Monday, May 18, 2026
Tax Anticipation Note (TAN)