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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Equivalent Taxable Interest Rate

What it is:

An equivalent taxable interest rate (also called equivalent taxable yield) is the return that is required on a taxable investment to make it equal to the return on a tax-exempt investment. The equivalent taxable interest rate is commonly used when evaluating municipal bond returns.
 

How it works (Example):

The formula for equivalent taxable interest rate is:

    R(te) = R(tf) / (1 - t)

    Where:

    R(te) = equivalent taxable interest rate for the investor

    R(tf) = return on tax-free investment (usually a municipal bond)

    t = investor's marginal tax rate

For example, let's assume Investor A, who is in a 28% tax bracket, is considering whether to invest in a municipal bond with a 10% coupon rate. Using the formula above, we can calculate that, for this investor, the municipal bond's equivalent taxable interest rate is:
 
    R(te) = 0.10 / (1 - 0.28)
    R(te) = 0.1389 = 13.89%
 
Therefore, a taxable bond would have to return a yield greater than +13.89% to become more profitable to this investor than the municipal bond.
 
The tax-free advantage of municipal bonds can make a tremendous difference in an investor's yield, especially if the investor is in a high tax bracket. For example, let's assume another investor, Investor B, only has a marginal tax rate of 20% and is considering whether to invest in that same 10% municipal bond. Using the formula above, we can calculate that Investor B's equivalent taxable interest rate for the same bond is:
 
    R(te) = 0.10 / (1 - 0.20)
    R(te) = 0.125 = 12.5%
 
For Investor A, a taxable bond would have to return more than +13.89% to become more favorable than the 10% municipal bond. But Investor B's lower tax bracket means that a taxable bond would only have to return more than +12.5% to become more favorable than the same 10% municipal bond.

Why it Matters:

Municipal bonds usually offer lower returns than similar taxable corporate bonds. But how does the investor know if the tax savings from the municipal bond will make up for its lower return? The equivalent taxable interest rate can help investors decide, because it facilitates apples-to-apples comparisons among securities with different tax consequences.

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