NASAA Series 66 Uniform Combined State Law ExaminationClient Investment Recommendations and StrategiesHard
A client is considering the purchase of a municipal bond with a coupon rate of 4.5% and a yield to maturity of 4.2%. The client is in the 35% federal tax bracket and a 5% state tax bracket. What is the approximate tax-equivalent yield (TEY) of this municipal bond for this client, assuming the bond is exempt from both federal and state taxes in their resident state?
- A6.00%
- B6.92%
- C7.50%
- D6.54%
Show answer & explanationAnswer & explanation
Correct answer: C. 7.50%
The total tax bracket is 35% (federal) + 5% (state) = 40%. Since the bond is exempt from both federal and state taxes, the tax-equivalent yield (TEY) is calculated as: Municipal Yield / (1 - Total Tax Rate). TEY = 4.5% / (1 - 0.40) = 4.5% / 0.60 = 7.50%.
Why the other options are wrong
- A. Incorrect calculation. Does not use the correct total tax rate or municipal yield.
- B. Incorrect calculation. Does not use the correct total tax rate or municipal yield.
- D. Incorrect calculation. Likely uses only federal tax rate or miscalculates total tax rate.
Tax-Equivalent Yield (TEY)
The yield that a taxable bond would have to offer to produce the same after-tax return as a tax-exempt municipal bond, taking into account the investor's tax bracket.
- TEY = Municipal Yield / (1 - Investor's Tax Rate).
- Used to compare taxable and tax-exempt investments.
- Higher for investors in higher tax brackets.
- Considers federal, and sometimes state/local, tax exemption.
Memory trick: TEY: Muni yield, divided by 'one minus your tax shield'!