What is Yield Equivalence?
The formula to calculate yield equivalence for a taxable security is:
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 issued by City ABC. The Company XYZ bonds are yielding 7%, and the City ABC bonds are yielding 6%. He is in the 35% .
At first glance, it seems that the investor should choose the Company XYZ bonds (all else being equal). After all, the money.is higher, and the investor stands to make more
However, the answer may change once the investor accounts for the fact that he must payon the 7% he earns on those Company XYZ bonds and no on the 6% earned from City ABC. Using the equivalence formula, we can calculate what the Company XYZ is really yielding after :
Equivalence = .07 x (1 - 0.35) = 0.0455 or 4.5%
So in other words, the Company XYZ taxes, and the City ABC bonds 6% after . All else being equal, the City ABC bonds turn out to be the better deal.yields 4.5% after
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 if they were taxable:
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 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 .).
Why Does Yield Equivalence Matter?
Most income and gains earned on them. However, the income from generally does not carry this requirement. Investors and analysts must always keep this in mind when comparing the opportunities in with other . The yields may be lower on , 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 .come with the requirement to pay on the