Tax-Equivalent Yield (TEY): Comparing In-State Municipal vs. Corporate Yields
An investor residing in California is in a 37% Federal marginal income tax bracket and a 13% California state income tax bracket (50% combined marginal tax rate). The investor is evaluating a California municipal bond offering an in-state tax-exempt yield of 4.20%. What corporate taxable bond yield must the investor obtain to achieve an equivalent after-tax return?
Tax-Equivalent Yield = Municipal Yield / (1 - Combined Tax Rate) = 4.20% / (1 - 0.50) = 4.20% / 0.50 = 8.40%.
Complete Analysis & Legal Rationale
Because interest paid on in-state municipal bonds is exempt from both federal and state income taxes for residents of that state ('double tax-free'), the full combined tax rate applies. Tax-Equivalent Yield (TEY) = Municipal Tax-Free Yield / (1 - Combined Tax Rate). Here: 4.20% / (1 - 0.50) = 4.20% / 0.50 = 8.40%. The investor would need an 8.40% yield on a fully taxable corporate bond to net the same after-tax return as the 4.20% muni 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:
Tax-Equivalent Yield = Municipal Yield / (1 - Combined Tax Rate) = 4.20% / (1 - 0.50) = 4.20% / 0.50 = 8.40%.
Fails to adhere to municipal bond rules regarding B.
Fails to adhere to municipal bond rules regarding C.
Fails to adhere to municipal bond rules regarding D.
Official Standard: Because interest paid on in-state municipal bonds is exempt from both federal and state income taxes for residents of that state ('double tax-free'),