What is referred to as the tax-equivalent yield for a taxable bond?

The tax-equivalent yield for a taxable bond refers specifically to the yield that must be offered by a taxable bond in order for it to be equivalent to the yield from a tax-exempt municipal bond. This calculation is essential for investors who are comparing taxable and tax-exempt investments, as it allows them to see what the taxable bond would need to earn to be as appealing as a tax-free option, given the investor's particular tax situation.

This yield takes into account the investor's marginal tax rate, allowing them to compare a lower-yielding tax-exempt bond with a higher-yielding taxable bond. The concept hinges on the idea that a municipal bond may offer a lower yield since the interest earned is not subject to federal (and sometimes state) taxes, making it vital for investors to equate the two types of investments on a common basis after accounting for taxes.

By calculating the tax-equivalent yield, investors can make informed decisions, ensuring they consider not just the nominal yield but also the impact of taxes on their actual returns.