What Is Yield Equivalence?
Yield equivalence is the interest rate on a taxable security that would generate a return equivalent to the return of a tax-exempt security and vice versa.
Knowledge of Yield Equivalency
Investors in municipal bonds are interested in yield equivalency because they want to know whether the tax benefits of their bonds will offset their lower yields when compared to equivalent-duration taxable securities. Investors sometimes use yield equivalency as a comparative tool to see if a tax-exempt or tax-free investment will provide a higher return than a taxable one.
The following formulas may be used to determine yield equivalency:
Taxable Yield Equivalence=Tax-Exempt Yield/(1−Tax Rate)
and
Tax-Exempt Yield Equivalence= Taxable Yield ×(1−Tax Rate)
Divide the tax-exempt yield of the bond by one minus the investor’s tax rate to get the yield equivalency between tax-exempt and taxable securities. Consider the following scenario: You wanted to know what the interest rate on a taxable corporate bond would have to be to get the same return as investing in a 6% tax-exempt municipal bond. To get a tax rate of 24%, remove 0.24 from 1 and add 76 to that amount. When you divide the tax-exempt yield, which is 6, by 76, you get 7.9.
According to this computation, to equalize the 6% return on the tax-exempt investment, you would want a 7.9% return on the taxable investment. On the other hand, a return of 9.2% on your corporate bond would be required if you were in the 35% tax bracket to equal the 6% return on your muni investment.
On the other hand, you can determine the comparable rate on a tax-exempt investment if you know your taxable rate of return. Multiplying the taxable rate by one less your tax rate is how you achieve this. In other words, to equal the after-tax return on a taxable asset, you need a 4.6% return on a tax-exempt investment if your taxable return is 6% and your rate of taxation is 24%.
New Tax Rates on Marginals
The Tax Cuts and Jobs Act passed in late 2017, resulted in various changes to income brackets and marginal tax rates starting in 2018. 1. The amount of tax that income earners must pay on each extra dollar of income is known as the marginal tax rate. Taxpayers get less money per dollar earned than they would have on previously earned dollars when the marginal tax rate rises.
Various tax rates are applied to multiple income levels under tax systems that use marginal tax rates; the tax rate increases with income. However, it’s crucial to remember that when income travels throughout the marginal tax rate schedule, it is taxed at many rates rather than just one.
Investors should be aware of these new tax rates and adjust their yield equivalency formulas appropriately when determining the yield equivalency between tax-free and taxable assets.
Conclusion
- The interest rate on a taxable asset that would provide a return equal to that on a tax-exempt investment, and vice versa, is known as yield equivalency.
- Investors in municipal bonds are interested in yield equivalency because they want to know whether the tax benefits of their bonds will offset their lower yields when compared to equivalent-duration taxable securities.
- When determining the yield equivalency between taxable and tax-free assets, investors should consider current tax rates.
