Tax-Equivalent Yield (TEY): How to Calculate the True Value of Municipal Bonds
Tax-Equivalent Yield (TEY): How to Calculate the True Value of Municipal Bonds
CORE INSIGHTS
- The Illusion of Yield: A 4% Municipal Bond often puts more cash in your pocket than a 6% Corporate Bond because it is tax-free.
- Bracket Dependent: The higher your tax bracket, the more valuable tax-free income becomes. For those in the 37% bracket, the boost is massive. IRS Pub 550
- The Formula: To compare apples to apples, you must calculate the “Tax-Equivalent Yield” to see what a taxable bond would need to pay to match the Muni.
In Fixed Income investing, what you keep matters more than what you earn. Municipal Bonds (Munis) pay tax-free interest. Because of this perk, their headline rates look low. But for high earners, the Tax-Equivalent Yield (TEY) reveals their true, hidden power.
What-If Scenario: Corp (6%) vs. Muni (4.5%)
Investor: 37% Federal Tax Bracket
| Bond Type | Headline Yield | Tax Bite (37%) | After-Tax Pocket |
|---|---|---|---|
| Corporate | 6.00% | -2.22% | 3.78% |
| Municipal | 4.50% | 0% | 4.50% Tax Exempt |
Visualizing the TEY Multiplier
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*Figure 1: The value of a 4% Tax-Free Yield skyrockets as your tax bracket increases.*
Strategic Action Steps
1
Identify Your Marginal Rate
Determine your top federal tax bracket. Add 3.8% if subject to NIIT. Add state tax if buying home-state bonds.
Determine your top federal tax bracket. Add 3.8% if subject to NIIT. Add state tax if buying home-state bonds.
2
Calculate the TEY
Use the formula:
Use the formula:
Muni Yield / (1 - Tax Rate). Compare this number against Treasury or Corporate yields.
3
Execute the Trade
If TEY > Taxable Yield, buy the Muni. If TEY < Taxable Yield, buy the Corporate Bond (ideally in an IRA).
If TEY > Taxable Yield, buy the Muni. If TEY < Taxable Yield, buy the Corporate Bond (ideally in an IRA).
The Bottom Line: Who Should Choose What?
- Choose Munis: Investors in the 32% bracket or higher, especially in taxable accounts.
- Choose Taxable Bonds: Retirees in low brackets (10-12%) or for IRA holdings.
What is the Tax-Equivalent Yield formula?
The formula is: Tax-Free Yield / (1 – Marginal Tax Rate). It converts tax-free yield to a taxable equivalent.
Does TEY include state taxes?
Standard TEY uses federal rates. If you buy home-state Munis (Double Tax-Free), add your state rate to the denominator for accuracy.
At what tax bracket do Munis make sense?
Usually the 24% bracket and above. For 32%+, the advantage is substantial.
Disclaimer: This content is for informational purposes only. Consult a professional.