Tax-Equivalent Yield

First, let’s get some groundwork laid out with tax-free municipal bonds. Tax-free municipal bonds are given out by states, municipalities, and counties that aren’t taxed. However, tax-free municipal bonds also typically come with measly yields.

For an investor looking to invest in bonds, they have to decide: do I choose to invest in bonds that are taxed that may have higher yields, OR do I choose to invest in tax-free municipal bonds, which aren’t taxed but may have lower yields? To help investors decide, they can calculate the tax equivalent yield, like so:

Tax equivalent yield = Tax-free municipal bond yield / (1 - Tax rate)

The tax equivalent yield calculates the pre-tax yield a taxable bond needs for its yield to equal the yield you’d get from a tax-free municipal bond. It tells investors: taking into account taxes for the taxed bond, which type of bond (tax-free or taxed) will give me higher yields?

If it’s higher than the tax-free alternative, it would make more sense to go with the taxed bond. If it’s lower than the tax-free alternative, that means it’d be better to go with tax-free municipal bonds. See: Corporate Bonds.