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The term “tax-equivalent yield” refers to the comparison of the returns of a tax-exempt bond to a fully taxable bond. Some fixed-income instruments, such as municipal bonds and US Treasuries, offer tax breaks but often give lesser returns than fully taxable securities, such as corporate bonds. Investors should use the tax-equivalent yield to decide whether a tax-exempt bond is a good fit for their portfolio.

Tax-equivalent yield produces the yield that a fixed-income investment would have to offer to produce the same returns if it were fully taxable. That number will differ from person to person since each individual can have different federal, state, and local tax rates.

Tax-equivalent yield gives investors a framework to evaluate two bonds with different tax treatments side by side. However, it shouldn’t be the only factor in an investment decision. The metric cannot account for the level of risk associated with a security. Riskier securities should have higher tax-equivalent yields than safer securities.

Tax-Equivalent Yield Formula

Depending on an investor’s tax bracket, a municipal bond may not be the best investment decision for their portfolio. An investor’s tax bracket will depend on their filing status and income. The federal income tax brackets for 2023 and 2024 are 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

To calculate the taxable equivalent yield of a tax-free municipal bond, use the following formula. Be sure to include any state taxes along with your federal tax rate. This formula can be reversed to determine the tax-free equivalent yield of a municipal bond that would match the return on a taxable bond.

An investor’s tax rate plays a significant role in the resulting tax-equivalent yields. For example, assume there is a tax-free bond that is yielding 7%. A decision to invest in this particular bond or any of the many taxable choices available greatly depends on the investor’s marginal tax bracket. In 2023, there are seven different marginal tax-rate brackets in the U.S.: 10%, 12%, 22%, 24%, 32%, and 35%. The tax-equivalent yield calculations for these brackets are as follows:

  • 10% Bracket: R(te) = 7% / (1 – 10%) = 7.78%
  • 12% Bracket: R(te) = 7% / (1 – 12%) = 7.95%
  • 22% Bracket: R(te) = 7% / (1 – 22%) = 8.97%
  • 24% Bracket: R(te) = 7% / (1 – 24%) = 9.21%
  • 32% Bracket: R(te) = 7% / (1 – 32%) = 10.29%
  • 35% Bracket: R(te) = 7% / (1 – 35%) = 10.77%
  • 37% Bracket: R(te) = 7% / (1 – 37%) = 11.11%

Given this information, assume there is a taxable bond that is yielding 9.75%. In this situation, investors in the first four marginal tax brackets would be better off investing in the taxable bond because, even after paying their tax liability, they would still earn more than a 7% non-taxable bond. Investors in the highest three brackets would be better off investing in the tax-free bond. However, none of this is investment advice; a tax or financial advisor should be consulted.

An investor in the 22% federal income tax bracket (with no state taxes) owns a tax-exempt municipal bond with an 8% coupon rate. To calculate the fully taxable equivalent yield that a taxable bond would have to earn to match the municipal bond’s yield, use the above formula.

In other words, a taxable bond would have to earn an equivalent yield of 10.26%; after taxes are deducted this bond would match the 8% return of the tax-free municipal bond.

If the marginal tax rate is higher, the required fully taxable equivalent yield will also be higher than 10.26%. So, if all else remains the same—the only difference being that the investor is in the 37% tax bracket—the fully taxable equivalent yield would have to be.

The tax-equivalent yield is the return that a taxable bond needs to possess for its yield to equal the yield on a comparable tax-exempt bond, such as a municipal bond. The way a bond’s interest income—also called coupon payments—is taxed varies according to the type of bond and where it’s issued. Coupon payments from a U.S. Treasury bond are free from state and local taxes. Coupon payments from municipal bonds are also exempt from regular federal income tax.

What is Yield Income?

Yield and return are two measures of an investment’s performance. Here’s an overview of how they differ and how you may use them to monitor the performance of your investments.

Yield refers to how much income an investment generates, separate from the principal. It’s commonly used to refer to interest payments an investor receives on a bond or dividend payments on a stock.

Yield is often expressed as a percentage, based on either the investment’s market value or purchase price. For example, let’s say bond A has a $1,000 face value and pays a semiannual coupon of $10. Over one year, bond A yields $20, or 2%. This is known as the cost yield because it’s based on the cost or value of the bond.

Read Also: How Long Does it Take to Get a Car Tax Refund?

However, most people buy bonds on the secondary market and not directly from the issuer, meaning they pay more or less than face value. If you’re considering purchasing the same bond A for $900, the $20 coupon payments based on the current $900 price would be a yield of 2.2%. This is known as the current yield because it’s based on the current price of the bond.

Yield is also a commonly used term when discussing dividend stocks. For example, let’s say you purchase 100 shares of XYZ for $50 ($5,000 total). Each quarter, XYZ pays a dividend of 50 cents per share. Over a year, you would receive $200 in dividend income (50 cents x 4 quarters = $2 x 100 shares). Your initial investment of $5,000 yielded 4% ($200 / $5,000 x 100).

What is return on investment?

Of course, it’s likely that XYZ’s share price changed over that same time, which is where return can be helpful. Return is a measure of an investment’s total interest, dividends and capital gains, expressed as a financial gain or loss over a specific timeframe.

Return provides a glimpse of the investment’s prior performance and helps determine if a particular investment has been profitable over time. If stock XYZ ended the year at $55 per share, your total return would be equal to the increase in share price plus the dividends, or $700 ($5 + $2 = $7 x 100 shares). That same $5,000 investment returned 14% ($700 / $5,000 x 100). 

Using yield and return together

Yield and return should be used together to help you evaluate an investment’s overall performance. 

Consider the earlier example of stock XYZ. Let’s say XYZ shares lost value over the year and are now valued at $45 each. The total return for that investment would be negative; you would have lost $300, or 6% ($200 in dividends – $500 in principal). However, the yield didn’t change. You still received $200 in dividend income.

Investing in stocks based on their yield could prevent you from having to sell shares to generate income. In a market downturn, this can help you avoid selling shares at a loss. 

Return can be used to assess not only individual investments or an entire portfolio. Doing so can help determine the overall performance and pinpoint whether certain underperforming investments should be sold, and the money reinvested elsewhere.

The risk factor

Risk is an important consideration for an investment’s yield because high-yield investments may carry more risk.

As an example, let’s say company B wants to sell bonds. If investors think company B is at risk of missing coupon payments and/or going bankrupt, the company likely needs to pay a higher yield on those bonds to compensate for the risk. To assess the risk of a bond in comparison to its yield, investors often look at the bond’s rating. It’s no surprise that the lowest-rated debt often has the highest yield. In fact, the term “high-yield” and “junk” are often used interchangeably when discussing poorly rated debt.

With stocks, if a company is paying high dividends, it may not be reinvested in the company and growth, which could jeopardize the investment long term. It’s important to look at how the dividend payments fit into the company’s overall financials. If, for example, the company consistently reports negative earnings (i.e., losing money) but is still paying dividends, it may be tapping into cash on hand or other sources to afford those payments. This could signal long-term problems or even future elimination of dividends.

You should consider your investment goals and tolerance for risk when determining if an investment is the right fit for your portfolio. And once you’re ready to pull income from your investments, consider making an appointment with a financial professional to assess your goals and help make sure your withdrawal plans are aligned with your investment objectives. 

What is the Difference Between Yield and Income?

What is Income?

When investment professionals talk about income, they can be referring to several slightly different concepts. But the most common (and useful) sense of the word is “natural income.”

Natural income is the cash flow generated by a set of assets. In the fund investment world, this is the cash produced by securities in a portfolio, whether it’s in the form of dividends from equities, coupons from bonds or rental income from real estate.

Importantly, natural income does not include cash generated from selling assets, i.e., from liquidating the underlying capital. If the assets in a portfolio are a factory, then income can be thought of as the factory’s output. If you dismantle the factory, then output falls. In the same way, liquidating assets may create a one-off gain, but future income is diminished.

What is Yield?

Yield is a measure of return. Again, there are different definitions, but “current yield” is particularly helpful from the perspective of income investing.

Current yield is the percentage measure of income as a proportion of the price of an asset. Because it is based on the current price, as opposed to the face value, it can differ from income measures such as the coupon rate of a bond. The current yield comes into its own as an easy way to compare investments; it’s a quick frame of reference for income today.

An investor in the units of an income fund that makes distributions receives a regular payment. This payment comes from the income generated by a fund’s assets, the realized gains on those assets, the actual capital of the assets or a combination of these three. The distribution can be pre-specified, so investors know beforehand what they’re getting, or it can vary, depending on the performance of the underlying assets. It is important that investors know what the distribution is based on, because different kinds of distributions have benefits and drawbacks.

For example, if a fund makes distributions from its capital base, it reduces the potential for future income generation, because the fund will have fewer assets, even though it can make higher payouts in the meantime. Using realized gains for distributions gives up the opportunity to reinvest and build assets for the future in favor of a short-term windfall.

What is Tax Equivalent Yield and Why Does It Matter?

Bonds are an important component of any financial portfolio and provide a useful source of diversification because stocks and bonds are negatively correlated. An allocation to bonds in a portfolio can help to minimize overall risk. Fixed income instruments generate a consistent stream of income through coupon payments.

However, bonds come in a variety of flavors, and it is critical to understand the complexities, notably the tax implications, associated with fixed-income investing. Bonds can be taxable or tax-exempt, and tax-equivalent yield allows investors to compare returns from taxable and tax-exempt instruments in order to make informed investment decisions.

Corporate vs Municipal Bonds

A bond, a type of fixed-income instrument, represents a loan made to a borrower by an investor. Corporations issue bonds, as do the federal government, states, and municipalities.

Companies issue bonds to raise capital for many different purposes, ranging from building new facilities and investing in new equipment to funding operations and growing their businesses.

Bonds are issued at par, or face value, and pay a specified amount of interest in annual or semi-annual coupon payments. When the bond matures, the investor receives the face value of the bond. Investors who purchase corporate bonds pay taxes on interest income and capital gains.

Municipal bonds are issued by state and municipal governments to finance operating expenditures, fund capital projects, and support public institutions and public works projects.

Municipal bonds are tax-exempt investments, and municipal bondholders do not pay federal income tax on interest income. Municipal bonds may also be exempt from state and local taxes if the bondholder is a tax resident in the issuing state.

Understanding Bond Yields and Taxation

Yield is the return an investor expects to receive over each year a bond is held until maturity. If the investor is holding a corporate bond, interest will always be subject to tax.

As mentioned above, muni bonds are exempt from federal taxes and may be exempt from state taxes under certain conditions (when the bondholder is a resident taxpayer in the issuing state). Treasury bonds issued by the U.S. government are taxed at the federal level but exempt from state and local tax.

Coupon payments are taxed, and if bonds are sold at a profit prior to maturity the holder may be subject to capital gains tax as well.

To calculate the tax-equivalent yield, you need to know the yield on the tax-exempt municipal bond and your marginal income tax rate. With this information, you can calculate the tax-equivalent yield using the following formula:

Tax Equivalent Yield = Tax Exempt Yield / (1 – Marginal Tax Rate)

Say for example that you are considering two bonds, a taxable corporate bond that offers a 4.75% yield and a tax-exempt municipal bond that offers a yield of 4%. You are in the 24% tax bracket.


4% / (1 – 0.24) = 5.26%

A tax equivalent yield of 5.26% means that you would have to choose a taxable bond yielding 5.26% to enjoy the same after-tax yield as the municipal bond. The tax equivalent yield on the municipal bond is 0.51% higher than the yield of the taxable bond. Therefore, you should buy the municipal bond.

The higher your income and tax bracket, and the higher the yield on the municipal bond, the more the taxable corporate bond will need to yield.

As with any investment, risk and return are correlated in the fixed-income universe. Credit rating agencies such as Standard & Poor’s and Fitch assign credit ratings to borrowers. Each agency has its own designation.

The AAA rating indicates the highest level of creditworthiness, and bonds ranging from AAA to BBB are designated as investment grade. Bonds with lower ratings fall into the “high yield” or “junk” category and are considered speculative with a significantly higher level of default.

Municipal bonds are generally lower-risk instruments, although that is not always the case, and consequently, yields are lower.

When comparing a muni to a corporate bond, it’s important to compare bonds with similar credit ratings. A high-yield bond may have an expected return significantly higher than the tax-equivalent yield, but the higher yield comes at vastly greater risk.

Final Words

Comparing the yield of a taxable bond to that of a tax-exempt bond is misleading since the taxable bond yield doesn’t take tax liability into account.

Any investor considering an investment in muni bonds, especially an investor in a high tax bracket, should always calculate the tax-equivalent yield to make sure they’re comparing apples to apples and making an informed investment decision.

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