What Is Yield Equivalence?
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What Is Yield Equivalence?

3 Min.

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. This concept is important for municipal bond investors who want to determine if the tax benefits of their bonds will compensate for the lower yields in comparison to similar taxable securities. It's crucial for investors to consider the current tax rates when calculating the yield equivalence between tax-free and taxable investments.

Basics

The concept of yield equivalence pertains to the interest rate associated with a taxable security, aiming to yield returns comparable to those of a tax-exempt security and vice versa.

Yield Parity in Investment Decision-Making

Yield equivalence plays a pivotal role in the considerations of municipal bond investors. It serves as a crucial yardstick to evaluate whether the tax advantages of municipal bonds can offset their comparatively lower yields when compared to taxable securities of a similar duration. Investors frequently turn to yield equivalence when assessing the potential for superior returns in tax-exempt or tax-free investments compared to their taxable counterparts.

Yield equivalence can be determined through the following formulas:

​Taxable Yield Equivalence = (Tax-Exempt Yield​​) / (1−Tax Rate)​

and

Tax-Exempt Yield Equivalence= Taxable Yield × (1−Tax Rate)

To compute the yield equivalence between tax-exempt and taxable securities, begin by dividing the tax-exempt yield of the bond by the result of subtracting one from the investor's tax rate. For instance, consider contemplating an investment in a 6% tax-exempt municipal bond while seeking to determine the interest rate required for a taxable corporate bond to yield an equivalent return. If your tax rate stands at 24%, perform the calculation as follows: 1 - 0.24 = 0.76. Subsequently, divide the tax-exempt yield, which is 6%, by 0.76, yielding 7.9%.

This calculation indicates that to match the 6% return of the tax-exempt investment, a 7.9% return is required from your taxable investment. Conversely, if you find yourself in the 35% tax bracket, achieving an equivalent return of 6% on your municipal investment would necessitate a 9.2% return on your corporate bond.

Conversely, if you are aware of your taxable rate of return, you can compute the corresponding rate for a tax-exempt investment by multiplying the taxable rate by the quantity obtained by subtracting your tax rate from one. For example, if your taxable return is 6% and your tax rate is 24%, you would require a 4.6% return on a tax-exempt security to attain the same after-tax return as a taxable security.

Revised Marginal Tax Rates

The Tax Cuts and Jobs Act, enacted in late 2017, led to significant alterations in marginal tax rates and income brackets starting from 2018. Marginal tax rates denote the taxation percentage on each additional dollar of income. As these rates climb, taxpayers receive a reduced portion of each newly earned dollar compared to their earnings from prior dollars.

Tax systems employing marginal tax rates apply varying tax rates to distinct income levels. The tax rate increases as income levels rise, applying multiple rates across the marginal tax rate schedule. It is imperative to recognize these new tax rates when computing yield equivalence between tax-free and taxable investments, ensuring they are factored into the yield equivalence equations.

Conclusion

Yield equivalence is vital for balancing taxable and tax-exempt investments while considering current tax rates. The Tax Cuts and Jobs Act of 2017 brought significant changes to tax rates and income brackets, emphasizing the need to account for these changes when calculating yield equivalence. This understanding is key for informed investment decisions in a dynamic economic landscape.

Yield Equivalence
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