What is the Taxable Equivalent Yield?

In general, tax-free investments, such as municipal bonds, have lower yields due to their tax-exempt status. When evaluating municipal bonds as a possible investment, you must use the taxable equivalent yield. This is because the taxable equivalent yield is the return required on a taxable investment to make it equal to the return on a tax-exempt investment.

Calculating the Taxable Equivalent Yield

Assuming that a municipal bond and taxable bond portfolio have similar maturities, the taxable equivalent yield of the municipal bond portfolio is as follows:

For example, if you are in the 22% marginal federal tax bracket and you are considering the purchase of a municipal bond with a 2.6% yield that is exempt from federal taxes, your taxable equivalent yield looks like this:

This means that for a taxable bond portfolio to make sense at a 22% tax bracket, it would have to yield more than 3.33%. The table below shows you more examples regarding taxable equivalent yield.

If you have questions about this, feel free to contact our office to discuss.

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