The tax-equivalent yield (TEY) of a bond is the return that a taxable bond needs in order to be equal to the return on a tax-exempt municipal bond. Knowing how to calculate the TEY on municipal bonds is a key element of determining whether they make sense for your investment portfolio over other types of bonds.
What Are Municipal Bonds?
A quick refresher on municipal bonds ("munis") and how they work is in order before doing the math. Munis are securities issued by state and local governments to raise money. If you buy a bond, you've lent money to that entity with the promise that it will pay you back with interest.
The interest usually takes the form of payments that are a percentage of the amount you loaned. When the bonds mature, you receive your money back. There are tax-free and taxable bond types that you can choose from.
Tax equivalent yield (TEY) is the tool used to compare tax-free munis to taxable bonds.
Most munis are tax-exempt on the federal and state levels, which sounds like a great deal at first. You don't want to pay taxes on your investment income when you have the option not to. Unfortunately, though, it isn’t quite that simple. If you're in a lower tax bracket, it might pay to invest in taxable bonds, since the they often bring higher pre-tax yields than the returns from tax-free munis.
Knowing how to calculate the TEY is the first step in making a comparison and finding out whether munis fit your needs.
Calculating Tax Equivalent Yield
The good news is that the calculation is not too hard.
Here's how you calculate the TEY in a few steps:
- Find the reciprocal of your tax rate (1 – your tax rate). If you pay 25% tax, your reciprocal would be (1 - .25) = .75, or 75%.
- Divide this amount into the yield on the tax-free bond to find out the TEY. For example, if the bond in question yields 3%, use (3.0 / .75) = 4%.
If you plug different tax rates into the equation above, you will see that the higher your tax rate, the higher the TEY, illustrating how tax-free bonds are best suited to those investors in the higher tax brackets.
Municipal bonds issued within your state of residence may be tax-free on both the federal and state levels, referred to as “double tax-free.”
Be sure to factor in your state's income tax rate when calculating your reciprocal in Step 1 of the tax-equivalent calculation.
For example, if your federal tax rate is 25%, and your state tax rate is 3%, the appropriate math in Step 1 would be (1 - .28) = .72.
Comparing Bond Issues
With this understanding, you can now make an apples-to-apples comparison between taxable and tax-free bond issues. Your earlier calculation determined that an equal taxable bond yield is 4%.
If you find a taxable bond of equivalent credit quality and time until maturity that yields more than 4%, you're better off investing in a taxable bond than the muni you're comparing.
Two Additional Wrinkles
First, U.S. Treasuries are tax-free at the state level. If you’re comparing a municipal bond to a Treasury issue, you need to take the yield to maturity of the Treasury at the time of purchase and multiply by (1 – your state's tax rate).
Second, if you sell an individual bond before it matures, or buy a bond fund and sell it again, you will be owe capital gains tax. Even though the income itself is tax-free, the capital gains are not.
The Bottom Line
It helps to do this simple math before you buy a municipal bond or muni bond fund. Tax-free income sounds like a great idea on paper, but you may be passing up the chance to earn higher after-tax income with your muni bond investments.
Frequently Asked Questions (FAQs)
Why would a bond's yield to maturity be less than the coupon rate?
If you're trading bonds on the secondary market, you must consider the yield to maturity rather than the coupon rate. The coupon rate is initially the same as the yield, but as the interest rate environment changes, the bond's price and yield do, too. When a bond's yield is less than its coupon rate, that means interest rates have fallen and bond prices have risen since the bond was first issued.
Which bonds are generally expected to have the highest yields?
Higher yields typically indicate a riskier asset. Therefore, the riskier the bond, the higher you can expect the yield to be. High-yield bonds that lack an investment-grade credit rating are known as "junk bonds." If you're seeking the highest possible yield, junk bonds are what you want. However, before you invest, consider the risk of default and how that could impact your investments.