Tax-Equivalent Yield

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Definition of 'Tax-Equivalent Yield'

The tax-equivalent yield is a measure of the return on an investment after taking into account the effects of income taxes. It is calculated by taking the after-tax yield on an investment and dividing it by the marginal tax rate.

For example, if an investment has an after-tax yield of 5% and the marginal tax rate is 25%, the tax-equivalent yield would be 6.67%. This is because 5% / .25 = 6.67%.

The tax-equivalent yield is useful for comparing investments with different tax treatments. For example, a municipal bond is exempt from federal income tax, so its tax-equivalent yield will be higher than that of a taxable bond with the same yield.

The tax-equivalent yield can also be used to compare investments with different maturities. For example, a bond with a long maturity will have a lower tax-equivalent yield than a bond with a short maturity, because the long-term bond will be taxed at a higher rate.

The tax-equivalent yield is a useful tool for investors, but it is important to remember that it is only an estimate of the after-tax return on an investment. The actual after-tax return will depend on the investor's individual tax situation.

Here are some additional points to keep in mind when using the tax-equivalent yield:

* The tax-equivalent yield is not the same as the yield to maturity. The yield to maturity is the total return on an investment, including both interest and capital gains. The tax-equivalent yield only takes into account the interest income.
* The tax-equivalent yield is only applicable to investments that generate interest income. It cannot be used to compare investments that generate capital gains, such as stocks and mutual funds.
* The tax-equivalent yield is based on the investor's marginal tax rate. If the investor's tax rate changes, the tax-equivalent yield will also change.

The tax-equivalent yield is a valuable tool for investors, but it is important to understand its limitations. By using the tax-equivalent yield, investors can make more informed decisions about their investments.

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