CFA Level IFixed IncomeHard
An investor in the 32% marginal tax bracket is comparing a tax-exempt municipal bond yielding 3.50% to a taxable corporate bond of similar risk and maturity. The taxable-equivalent yield the corporate bond must offer to match the municipal bond's after-tax return is closest to:
- A4.62%
- B5.88%
- C3.50%
- D5.15%
Show answer & explanationAnswer & explanation
Correct answer: D. 5.15%
Taxable-equivalent yield = tax-exempt yield / (1 − marginal tax rate) = 3.50% / (1 − 0.32) = 3.50% / 0.68 = 5.15%.
Why the other options are wrong
- A. Incorrect denominator; understates the required taxable yield.
- B. Overstates the required taxable yield beyond the correct calculation.
- C. Ignores the tax adjustment entirely.
Taxable-Equivalent Yield
The yield a taxable bond must offer to provide the same after-tax return as a given tax-exempt (e.g., municipal) bond, for an investor in a specific tax bracket.
- Formula: tax-exempt yield / (1 − marginal tax rate)
- Higher tax brackets make municipal bonds relatively more attractive
- Used to compare bonds with different tax treatments on an equal basis
Memory trick: 'Gross up the tax-free yield by dividing out the tax bite'