Tax-Equivalent Yield Comparison in Top Federal Bracket
A corporate executive in the 37% marginal federal tax bracket has $100,000 to invest in fixed income. She is comparing a high-grade municipal bond yielding 4.50% with an investment-grade corporate bond yielding 6.80%. Which bond provides the higher after-tax return, and what is the municipal bond's Tax-Equivalent Yield (TEY)?
TEY = Municipal Yield ÷ (1 - Tax Bracket) = 4.50% ÷ (1 - 0.37) = 4.50% ÷ 0.63 = 7.14%. Because 7.14% > 6.80%, the tax-free municipal bond offers a higher effective yield.
Complete Analysis & Legal Rationale
The investor pays 37% tax on corporate bond interest, leaving an after-tax yield of 6.80% × (1 - 0.37) = 4.28%. Since the municipal bond pays 4.50% tax-free (equivalent to 7.14% taxable), the municipal bond is mathematically superior.
Mathematical Step-by-Step Derivation
- Step 1: Formula: TEY = Municipal Yield ÷ (1 - Tax Rate)
- Step 2: Calculate: 4.50% ÷ (1 - 0.37) = 4.50% ÷ 0.63 = 7.1428%
- Step 3: Compare: 7.14% TEY > 6.80% Corporate Coupon -> Recommend Municipal Bond.
Distractor Autopsy (Why Other Options Are Traps)
FINRA exam writers design incorrect distractors using specific calculation mistakes and regulatory misconceptions. Review why each option succeeds or fails:
Accurately calculates TEY as 7.14% and correctly recommends the municipal bond.
Calculates corporate after-tax yield incorrectly (6.80% × 0.63 = 4.28%, which is LESS than 4.50%).
Fails to run tax adjustment math.
Multiplies by (1 + tax rate) instead of dividing by complement.
Official Standard: Governs federal tax-exempt status of municipal debt.