Tax-Equivalent Yield

Ottoline is in the top federal bracket and is investing $90,000 of taxable money for current income. She has a long horizon, ample liquidity elsewhere, and a moderate tolerance for risk. Which element of her investment profile most directly drives the choice between a corporate bond fund and a municipal bond fund?

1. A.Her time horizonTime horizon is a genuine profile element and would matter in choosing between short and long maturities. It does not distinguish a municipal fund from a corporate fund.
2. B.Her tax statusCorrect. The comparison between exempt and taxable income turns on the investor's marginal bracket, which is precisely what tax status captures.
3. C.Her risk toleranceRisk tolerance would help choose between investment grade and high yield. It does not answer the exempt-versus-taxable question when credit quality is comparable.
4. D.Her liquidity needsBoth funds are open-end funds redeemable daily, so liquidity is essentially identical. Her reserves sit elsewhere in any event.

Why: Municipal and corporate bond funds of comparable quality and maturity differ mainly in how their income is taxed. Whether the tax-exempt yield beats the taxable yield after tax depends on the investor's marginal bracket, so tax status is the deciding element. Her horizon, liquidity and risk tolerance are all satisfied by either choice.

Emi Eze is in an assumed 22% marginal tax bracket and is comparing a municipal bond yielding 6.30% with taxable bonds for a $68,118 allocation. What taxable yield would provide the same after-tax income as the municipal yield?

1. A.4.91%This computes an after-tax taxable yield rather than a taxable-equivalent yield.
2. B.7.69%This adds the tax rate to the municipal return instead of grossing it up correctly.
3. C.28.30%This treats the tax rate as percentage points of yield rather than a tax fraction.
4. D.8.08%This correctly divides the tax-exempt yield by one minus the stated tax rate.

Why: Taxable-equivalent yield converts a tax-exempt municipal yield into the taxable yield needed to leave the same after-tax income. Divide the municipal yield by one minus the assumed marginal tax rate.

Vikram Gomez is in an assumed 41% marginal tax bracket and is comparing a municipal bond yielding 3.90% with taxable bonds for a $148,566 allocation. What taxable yield would provide the same after-tax income as the municipal yield?

1. A.2.30%This computes an after-tax taxable yield rather than a taxable-equivalent yield.
2. B.44.90%This treats the tax rate as percentage points of yield rather than a tax fraction.
3. C.6.61%This correctly divides the tax-exempt yield by one minus the stated tax rate.
4. D.5.50%This adds the tax rate to the municipal return instead of grossing it up correctly.

Why: Taxable-equivalent yield converts a tax-exempt municipal yield into the taxable yield needed to leave the same after-tax income. Divide the municipal yield by one minus the assumed marginal tax rate.

A municipal bond yields 3 percent. For an investor in the 32 percent federal tax bracket, what is the approximate tax-equivalent yield?

1. A.2.04 percentThat multiplies the yield by the bracket instead of dividing by (1 minus the bracket).
2. B.9.38 percentThat result is far too high; the correct divisor is 0.68, not a much smaller number.
3. C.3.68 percentThat uses the wrong adjustment; divide 3 by 0.68.
4. D.4.41 percentCorrect — 3 percent divided by 0.68 equals about 4.41 percent.

Why: Tax-equivalent yield equals the muni yield divided by (1 minus the bracket): 3 percent divided by 0.68 equals about 4.41 percent.