Tax-Equivalent Yield Formula (Municipal Bonds)
Tax-equivalent yield is the pre-tax yield a taxable bond must offer to match a municipal bond's tax-free yield. The formula is tax-free yield divided by one minus the investor's marginal tax rate: a 4% muni for a 32% bracket equals 4% ÷ 0.68, or about 5.88%.
The formula
TEY = tax-free yield ÷ (1 − marginal tax rate). The higher the investor's tax bracket, the more valuable a municipal bond's tax exemption, and the higher the tax-equivalent yield.
When it applies
Municipal bond interest is generally exempt from federal income tax, and often from state tax for residents of the issuing state. Compare TEY to a taxable bond's yield to decide which investment has the higher after-tax return.
Frequently asked questions
What is Tax-Equivalent Yield?
Tax-equivalent yield is the pre-tax yield a taxable bond must offer to match a municipal bond's tax-free yield. The formula is tax-free yield divided by one minus the investor's marginal tax rate: a 4% muni for a 32% bracket equals 4% ÷ 0.68, or about 5.88%.
How does Tax-Equivalent Yield show up on the exam?
Always convert the tax bracket to a decimal and subtract it from 1 before dividing. Forgetting the subtraction is the most common error.
Practice this concept
Sources
- FINRA Series 7 content outline (municipal securities)
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