Taxable Equivalent Yield
Since the investor does not pay taxes on the interest from a municipal bond, the interest earned is worth more to the investor’s net worth bottom line than the taxable interest received from regular corporate bonds. One way to calculate this extra value is the Taxable Equivalent Yield.
The taxable equivalent yield of a bond is the interest rate a non-tax exempt bond would have to earn in order for the investor to end up with the same amount of money after taxes. In other words, since a 5% tax-free interest rate on a municipal bond would generate $50 of income which would not be reduced by taxes. A non-tax advantaged bond would earning 5% would also generate $50 of income, but then that amount would be reduced by the amount of taxes the investor would have to pay.
For example, an investor in the 28% tax bracket would owe $14 in taxes for the $50 of income and thus would only net $36.
But, if the investor earned approximately 7% (6.944%) on a regular taxable bond, then he would earn $70 in interest for which he would be required to pay approximately $20 ($19.60) for a net return of $50 just like the muni bond.
To calculate the taxable equivalent yield of a muni bond, subtract the investor’s tax bracket from 1 and then divide the tax-free yield by that number.
In our example above, the investor is in the 28% tax bracket, so 1 - .28 = .72 then we divide 5% by .72 or 0.05 / .72 to get 0.0694 or 6.94% which is the yield required from a taxable bond to equal the net return after taxes for that investor.
Keep in mind that the taxable equivalent yield changes for different tax brackets which makes muni bonds more attractive for taxpayers in higher brackets than those in lower tax brackets.