What it is:
An equivalent taxable interest rate (also called equivalent taxable yield ) is the return that is required on a taxable investment to make it equal to the return on a tax-exempt investment. The equivalent taxable interest rate is commonly used when evaluating municipal bond returns.
How it works/Example:
The formula for equivalent taxable interest rate is:
R(te) = R(tf) / (1 - t)
R(te) = equivalent taxable interest rate for the investor
R(tf) = return on tax-free investment (usually a municipal bond )
For example, let's assume Investor A, who is in a 28% tax bracket. is considering whether to invest in a municipal bond with a 10% coupon rate. Using the formula above, we can calculate that, for
this investor, the municipal bond's equivalent taxable interest rate is:
R(te) = 0.10 / (1 - 0.28)
R(te) = 0.1389 = 13.89%
Therefore, a taxable bond would have to return a yield greater than +13.89% to become more profitable to this investor than the municipal bond.
The tax-free advantage of municipal bonds can make a tremendous difference in an investor's yield, especially if the investor is in a high tax bracket. For example, let's assume another investor, Investor B, only has a marginal tax rate of 20% and is considering whether to invest in that same 10% municipal bond. Using the formula above, we can calculate that Investor B's equivalent taxable interest rate for the same bond is:
R(te) = 0.10 / (1 - 0.20)