An investor in a 32\% federal marginal income tax bracket is evaluating a tax-exempt munic… — FINRA SIE (Securities Industry Essentials)

An investor in a $32\%$ federal marginal income tax bracket is evaluating a tax-exempt municipal bond offering a yield of $4.76\%$ . What is the tax-equivalent yield (expressed as a percentage) that a fully taxable corporate bond would need to provide to match the after-tax yield of this municipal bond?

Answer: 7 %

Answer

The tax-equivalent yield required from a fully taxable corporate bond is

7.0\%

The tax-equivalent yield formula calculates the yield a taxable corporate bond must earn to equal the after-tax yield of a tax-exempt municipal bond. Using the formula

\text{TEY} = \frac{\text{Municipal Yield}}{1 - \text{Marginal Tax Rate}}

, we divide

4.76\%

(1 - 0.32) = 0.68

, resulting in

7.00\%

Step-by-Step Solution

Determine the tax-free factor

1 - 0.32 = 0.68

The investor retains

68\%

of earnings on taxable income after paying a

32\%

marginal income tax rate.

Calculate the tax-equivalent yield

\frac{4.76\%}{0.68} = 7.00\%

Dividing the tax-exempt yield by the after-tax retention factor gives the equivalent yield required from a fully taxable security.

Key Concept

Tax-Equivalent Yield (TEY)

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