Sunday, November 06, 2011

After Tax Yield of a Taxable Security

CFA Level 1 - Fixed Income Investments

The after-tax yield is the yield on a taxable bond after federal income taxes are paid. It is computed with the following formula.
Formula 14.5

After-tax yield = pre-tax yield * (1- marginal rate)

The marginal rate will vary depending on the tax bracket the investor is at that given time.

Example: Taxable Bond Yield
Taxable bond yield is 7.5%
The Marginal tax rate for this investor is 31%

After-tax yield = .075 * (1-.31)
= .05175
= 5.175%

Tax-Equivalent Yield
The tax-equivalent yield is the yield that must be offered on a taxable bond issue to give the same after-tax yield as a tax-exempt issue. It is computed with the following formula.

Formula 14.6
Taxable-equivalent yield = tax-exempt yield / (1- marginal tax rate)

Example: Tax-Exempt Yield
Tax exempt yield = 5.00%
Marginal Tax Rate = 31%

Taxable-equivalent yield = .05 / (1-.31)
= .05 / .69= .072464
= 7.2464 %

This means that a taxable issue must yield more than 7.25 % for the investor at the 31% tax bracket in order to beat the 5% yield offer in the tax-exempt bond.

Look Out!

Notice that the higher the marginal tax rate, the higher the taxable equivalent yield would be needed in the taxable bond market.
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