Tax-Equivalent Yield

Tax-equivalent yield is the yield a fully taxable investment would need to offer in order to match, after tax, the yield on a tax-exempt investment. Its purpose is comparison: a municipal bond paying 3 percent free of federal tax is not competing on level terms with a corporate bond paying 3 percent that will be taxed, and the calculation restates the exempt yield in taxable terms so the two can be set side by side.

The arithmetic is one division. Take the tax-exempt yield and divide it by one minus the marginal tax rate that would apply to the taxable alternative. The reverse direction is sometimes easier to think about: multiply a taxable yield by one minus the tax rate to get its after-tax yield, and compare that with the exempt yield directly. Both routes give the same ranking.

Choosing the rate for the denominator is where most of the judgment lives. The rate that belongs there is the marginal rate the taxable interest would face, which is not always the headline federal bracket. Three layers can apply. The federal marginal rate is the first. The net investment income tax adds 3.8 percent for a household above its threshold, and it reaches taxable bond interest while leaving tax-exempt interest alone, so it belongs in the comparison for anyone who pays it. State income tax is the third: where a municipal bond is issued by the investor's own state and is exempt from that state's tax as well, the state rate belongs in the denominator too.

Adding those rates together is an approximation, and it errs in one direction. State income tax is itself deductible for an itemizer, though only inside the capped deduction for state and local taxes, so simply summing the federal and state rates slightly overstates the combined burden for some taxpayers and not others. The sum is close enough for a first pass and wrong enough to be worth naming.

The calculation flatters tax exemption at high rates and not at low ones, which is the whole point. Because the denominator shrinks as the marginal rate rises, the same exempt yield grosses up to a larger number for a higher-rate investor. That is not a quirk of the arithmetic; it is why the municipal bond market exists in the shape it does. Issuers can borrow at yields below taxable rates because a particular class of buyer still comes out ahead, and buyers outside that class generally should not be there.

When a fund quotes the figure, the rules tighten. Rule 482 under the Securities Act, at 17 CFR 230.482(d)(2), permits an open-end fund to advertise a tax-equivalent yield only if it is computed by the method Form N-1A prescribes, is accompanied by quotations of yield and of total return, and is set out in no greater prominence than those. Form N-1A's own instruction is more precise than the popular formula: the fund divides "that portion of the Fund's yield ... that is tax-exempt by 1 minus a stated income tax rate and add[s] the quotient to that portion, if any, of the Fund's yield that is not tax-exempt." Two things follow. Only the exempt portion is grossed up, which matters for a fund that holds some taxable bonds. And the rate must be stated, because a tax-equivalent yield without a disclosed assumption is not a number at all.

A tax-equivalent yield is a comparison of yields and nothing else. It does not adjust for the credit risk difference between a general obligation bond and a corporate bond, for a difference in maturity or duration, or for the thinner secondary market most municipal bonds trade in. Nor does it account for the tax rules that apply when an exempt bond is bought at a discount in the secondary market, where part of the return can be ordinary income rather than exempt interest.

Start with the tax-exempt yield. Work out the total marginal rate that would apply to interest from the taxable alternative, including the net investment income tax and state income tax where they apply. Subtract that combined rate from one, and divide the exempt yield by the result.

A hypothetical example with invented yields. A general obligation bond issued by Priya's own state pays 3.4 percent, exempt from both federal and state income tax. Her federal marginal rate is 32 percent, her state rate is 5 percent, and her investment income is subject to the 3.8 percent net investment income tax. Taxable interest would therefore face roughly 32 plus 3.8 plus 5, or 40.8 percent. Her tax-equivalent yield is 3.4% divided by (1 − 0.408), which is 3.4% ÷ 0.592, or about 5.74 percent. A taxable bond of similar credit quality and maturity would have to pay more than 5.74 percent to beat it for her.

The same bond, a different buyer. Marcus holds the identical bond, but he is in the 12 percent federal bracket, lives in a state with no income tax, and is nowhere near the net investment income tax threshold. His denominator is 1 − 0.12, so his tax-equivalent yield is 3.4% ÷ 0.88, or about 3.86 percent. A taxable bond paying 4 percent beats the municipal bond comfortably for him and loses badly for Priya. Nothing about the bond changed.

What the calculation does well

• It converts an apples-to-oranges comparison into a single number a reader can act on.
• It makes the personal nature of the exemption obvious, which is the strongest argument against generic advice about municipal bonds.
• It is simple enough to do in your head at a rough level, and the reverse version, multiplying a taxable yield by one minus the rate, is simpler still.
• Regulated versions of the figure exist for funds, with a disclosed rate assumption and mandatory companion figures.

Where it misleads

• It compares only yield. Credit quality, maturity, call features and liquidity are all outside it, and municipal bonds and corporate bonds differ on every one of them.
• The answer is only as good as the marginal rate you put in, and using a top bracket rate that does not apply to you inflates the result.
• Summing federal and state rates ignores the interaction between them, which makes the combined figure an approximation.
• It assumes the exempt yield really is exempt. Private activity bond interest can be caught by the alternative minimum tax, out-of-state bonds are usually taxable at home, and a bond bought at a secondary-market discount can generate ordinary income.
• It says nothing about the effect tax-exempt interest has elsewhere on a return, such as the amount of a Social Security benefit that becomes taxable.