Key Takeaways
- TEY compares taxable and tax-exempt bond yields.
- Calculates pretax yield to match muni's after-tax return.
- Higher tax rates increase tax-equivalent yield advantage.
What is Tax-Equivalent Yield?
Tax-equivalent yield (TEY) represents the pretax yield a taxable bond must offer to match the after-tax return of a tax-exempt bond, typically a municipal bond. It allows you to compare taxable and tax-exempt bonds on an equal footing by adjusting for the impact of federal and state taxes.
This calculation is essential for evaluating bonds like municipal bonds against taxable alternatives, such as corporate bonds or bond ETFs. Understanding TEY helps you optimize your fixed income portfolio, including assets like BND.
Key Characteristics
TEY simplifies the comparison between taxable and tax-exempt bonds by quantifying tax effects. Key features include:
- Formula-based: Calculated as tax-exempt yield divided by one minus your marginal tax rate.
- Tax-adjusted comparison: Accounts for federal and sometimes state taxes, reflecting your specific tax situation.
- Applies to municipal bonds: Focuses on bonds usually exempt from federal income tax.
- Useful for high earners: Particularly valuable if you are in a higher tax bracket, where tax savings significantly impact returns.
- Relevant for fixed income investing: Helps contrast municipal bonds with taxable bond funds or ETFs, like those covered in our best bond ETFs guide.
How It Works
To compute TEY, divide the tax-exempt yield by 1 minus your marginal tax rate, which includes federal and applicable state taxes. This yields the taxable bond yield you would need to match the municipal bond’s after-tax return.
For example, if a municipal bond yields 4% and you are in the 24% tax bracket, the TEY is 5.26%. This means a taxable bond must yield at least 5.26% to be equally attractive. This method supports informed decisions between various fixed income instruments such as corporate bonds or ETFs.
Examples and Use Cases
Here are practical examples demonstrating TEY’s role in investment decisions:
- Municipal vs. Corporate Bonds: An investor in the 24% bracket comparing a 4% muni bond to a 4.75% corporate bond may find the muni more attractive once TEY is calculated.
- State Tax Impact: In high-tax states, including state taxes in TEY calculations further enhances muni bonds’ appeal, showing a taxable-equivalent yield higher than taxable offerings.
- Fixed Income Portfolios: Investors balancing municipal bonds with funds like BND or evaluating bond ETFs can use TEY to optimize after-tax returns.
Important Considerations
While TEY is a valuable tool, it’s important to consider factors beyond yield. Credit risk, liquidity, and inflation impact your total return and should be evaluated alongside TEY.
Also, TEY does not apply within tax-deferred accounts such as IRAs or 401(k)s, where tax advantages of municipal bonds are irrelevant. Using TEY calculators or consulting financial professionals can help tailor comparisons to your tax situation.
Final Words
Tax-equivalent yield lets you directly compare taxable and tax-exempt bonds by adjusting for your tax bracket. To make the most informed investment decision, calculate your TEY and compare it against available taxable bond yields before committing.
Frequently Asked Questions
Tax-Equivalent Yield (TEY) is the pretax yield a taxable bond must offer to match the after-tax yield of a tax-exempt bond, like a municipal bond. It helps investors compare taxable and tax-exempt investments on a level playing field by accounting for taxes.
TEY is important because municipal bonds usually have lower nominal yields but are exempt from federal and often state taxes. By calculating TEY, investors—especially those in higher tax brackets—can see if munis actually offer better after-tax returns compared to taxable bonds.
You calculate TEY by dividing the tax-exempt yield by one minus your marginal tax rate. The formula is TEY = (Tax-exempt yield) / (1 - Marginal tax rate), where the marginal tax rate includes federal and, if applicable, state taxes.
Yes, state taxes should be included in your marginal tax rate if you invest in municipal bonds issued by your state of residence. This can significantly increase the TEY and make muni bonds more attractive compared to taxable bonds.
Absolutely. TEY allows you to compare the effective return of tax-exempt municipal bonds to taxable corporate bonds by adjusting for taxes. If the TEY of a muni bond exceeds the yield on a taxable bond, the muni bond may offer a better after-tax return.
High-income investors in higher tax brackets, including those subject to surtaxes like the Medicare surtax, benefit most because they face higher taxes on interest income. TEY helps them identify when tax-exempt bonds provide superior after-tax yields.
Yes, many financial websites like Bankrate, Fidelity, and Eaton Vance offer calculators that automate TEY computations. These tools typically factor in your federal and state tax rates along with your residency to give you accurate comparisons.
