An investor in the 30\% marginal income tax bracket is considering purchasing a tax-exempt… — FINRA SIE (Securities Industry Essentials)

An investor in the $30\%$ marginal income tax bracket is considering purchasing a tax-exempt municipal bond offering a yield of $4.2\%$ . What is the tax-equivalent yield of this municipal bond?

Answer: 6 %

Answer

The tax-equivalent yield of the municipal bond is 6.0%.

The tax-equivalent yield formula determines the interest rate a taxable corporate bond must pay to equal the after-tax yield of a tax-exempt municipal bond. Dividing the municipal yield of

4.2\%

(1 - 0.30)

yields

6.0\%

Step-by-Step Solution

Calculate the tax complement factor

1 - 0.30 = 0.70

This represents the portion of taxable income an investor retains after paying federal income tax.

Divide the municipal yield by the tax complement factor

4.2% / 0.70 = 6.0%

This converts the tax-free yield of a municipal bond into the equivalent yield required from a fully taxable bond to achieve the same net return.

Key Concept

Tax-Equivalent Yield Calculation

Estimated Time:45s

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