Yield Equivalence
Yield equivalence represents a certain interest rate on securities that are subject to tax, which produce returns equivalent to returns of assets that are exempted from taxes. The situation applies in reverse as well.
Yield Equivalence explained
Yield equivalence is an important metric for those who invest in municipal bonds and want to understand whether low yields on some instruments will be offset by tax savings of bonds from this portfolio. When an investor needs to compare the amount of profit received from taxable instruments of his portfolio and that was obtained from tax-exempt investments, the yield equivalence indicator is applied.
Yield equivalence is calculated as follows using two formulas:
As an example, an investor is considering tax-exempt municipal bonds with a yield of 7%, but is wondering what corporate bond rate would have to be to earn the same return. If the tax rate is 37%, then 0.37 should be subtracted from 1, which will be .63. The second step is to divide the tax-free yield, which is 7 in this case, by the received figure, which is .63. So, the result is 11. It should be noted that an investor should take into account the current tax rates, when determining the yield equivalence.
That is, it turns out that an investor would need a return equal to 11% on taxable instruments in order to match the return level of 7% on investments that are exempted from taxes. If a tax bracket equals 25%, an investor would need a return of 9.33% on this corporate debt obligation to match the return level of 7% on his municipal bond.
Knowing the rate of return, which is taxed, it is possible to determine the equivalent rate on tax-free instruments. If a taxable yield is 7% and a tax rate is 37%, then an investor needs to earn a return of 4.41% on a tax-free security to compare with the return received after taxes on a security that is subject to tax.
Yield Equivalence and update marginal tax rates
The change in marginal tax rates and income brackets in 2018 was made following the law of the Tax Cuts and Job Act adopted in late 2017.
The marginal tax rate is the tax paid for each additional $1 of income by recipients of the income. The higher the marginal tax rate, the fewer taxpayers will receive on the $1 they earn.
Various income levels may be subject to various taxation rates, and this depends on the tax system that applies marginal tax rates. As a general rule, the higher the income, the higher the tax rate. Nevertheless, in many cases, the tax rate schedule is widely used, since not one value of the tax rate, but different ones, can be applied to the income received.
It should be noted that the current values of tax rates must be taken into account by investors who are trying to figure out the yield equivalence between instruments that are taxed and tax-free.
