What is Yield Equivalence?
The yield equivalence is the yield a taxable investment would have to offer to equal the tax-free yield on a municipal bond.
The formula to calculate yield equivalence for a taxable security is:
Yield equivalence = Taxable Yield x (1 - Tax Rate)
The formula to calculate yield equivalence for a tax-exempt security is:
Yield Equivalence = Tax-Exempt Yield / (1 - Tax Rate)
How Does Yield Equivalence Work?
Let's assume an investor is trying to decide whether to invest in the bonds of Company XYZ or in municipal bonds issued by City ABC. The Company XYZ bonds are yielding 7%, and the City ABC bonds are yielding 6%. He is in the 35% tax bracket.
At first glance, it seems that the investor should choose the Company XYZ bonds (all else being equal). After all, the yield is higher, and the investor stands to make more money.
However, the answer may change once the investor accounts for the fact that he must pay taxes on the 7% he earns on those Company XYZ bonds and no taxes on the 6% earned from City ABC. Using the yield equivalence formula, we can calculate what the Company XYZ bond is really yielding after taxes:
Yield Equivalence = .07 x (1 - 0.35) = 0.0455 or 4.5%
So in other words, the Company XYZ bond yields 4.5% after taxes, and the City ABC bonds yield 6% after taxes. All else being equal, the City ABC bonds turn out to be the better deal.
Conversely, if you wanted to compare the two bonds on a taxable basis, you could apply the formula to the tax-exempt City ABC bonds in order to determine what they would have to yield if they were taxable:
Yield Equivalence = .06 / (1 - 0.35) = 0.0923 or 9.23%
Here, the City ABC bonds would have to pay 9.23% if they were taxable (and that would compare favorably to the taxable 7% Company XYZ is offering). note that the investor's tax bracket makes a big difference in these calculations. The higher it is, the bigger the disparity between the taxable and tax-free yields.
Why Does Yield Equivalence Matter?
Most investments come with the requirement to pay taxes on the income and gains earned on them. However, the income from municipal bonds generally does not carry this requirement. Investors and analysts must always keep this in mind when comparing the opportunities in municipal bonds with other investments. The yields may be lower on municipal bonds, but when you factor in the notion that those yields are mostly tax-free, their yields start to look pretty good for some investors. This is one reason investors in high tax brackets may be particularly drawn to investing in municipal bonds.