FINRA Series 7Investment Information and Suitable RecommendationsHard
A client in the 32% federal tax bracket is comparing a municipal bond yielding 4% to a corporate bond of similar credit quality. What yield must the corporate bond offer to provide an equivalent after-tax return?
- A4.35%
- B5.26%
- C6.25%
- D5.88%
Show answer & explanationAnswer & explanation
Correct answer: D. 5.88%
Taxable equivalent yield = Municipal yield ÷ (1 − tax bracket) = 4% ÷ (1 − 0.32) = 4% ÷ 0.68 = 5.88%. The corporate bond would need to yield approximately 5.88% to match the municipal bond's after-tax return.
Why the other options are wrong
- A. Incorrect — this understates the required yield using an incorrect divisor.
- B. Incorrect — this results from dividing by an incorrect tax rate assumption.
- C. Incorrect — this overstates the yield needed for equivalence.
Taxable Equivalent Yield (TEY)
TEY calculates the yield a taxable bond must offer to match the after-tax return of a tax-exempt municipal bond, using the formula: municipal yield ÷ (1 − tax bracket).
- Formula: Muni yield ÷ (1 − tax rate)
- Higher tax brackets increase TEY, favoring munis
- Used to compare munis with taxable bonds
- Also can invert to find muni-equivalent yield from taxable yield
Memory trick: TEY: 'Muni yield stretched by what the tax man takes.'