The term taxable equivalent yield refers to a calculation that converts the yield on a tax-exempt investment to that of a taxable investment. Taxable equivalent yield is frequently used when investing in municipal bonds.
Taxable Equivalent Yield (%) = Return on Tax-Exempt Investment / (1 - Tax Rate)
Also known as the taxable equivalent rate, the taxable equivalent yield provides investors with a measure they can use to compare the yields on taxable and tax-exempt bonds. Since the calculation is sensitive to the investor's marginal income tax rate, two investors faced with the same choice between a taxable and tax-exempt bond can come to different conclusions as to which provides a higher after-tax return.
Since the income derived from most corporate bonds is subject to federal income tax (and oftentimes state income taxes too), the only way an investor can make a fair yield comparison to a municipal bond is to adjust the yield for income taxes. Calculating the taxable equivalent yield provides for that direct comparison.
Two investors are faced with a decision between a municipal bond paying 4.00% and a corporate bond paying 5.75%. Investor A is in the 24% tax bracket, while Investor B is in the 37% tax bracket. The taxable equivalent yield for each investor is shown below:
For Investor A
= 4.00 / (1 - 0.24), or 5.26%
For Investor B
= 4.00 / (1 - 0.37), or 6.35%
So, while the corporate bond paying 5.75% would provide Investor A with a higher return than the municipal bond with a taxable equivalent yield of 5.26%, Investor B would realize higher returns by purchasing the municipal bond with a taxable equivalent yield of 6.35%.