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Municipal Perspective published on January 26, 2018

Tax-Equivalent Yields and the New Tax Law

Fixed income investors have many options for meeting their investment objectives, including both taxable and tax-exempt bonds. However, it is important to remember that when comparing tax-exempt bonds with taxable bonds, you can’t just compare the absolute yields of the two. The value of the tax exemption – which will vary by an individual’s tax rate – must be considered when seeking to position portfolios to maximize after-tax return.

In this blog post, we demonstrate the calculation for tax-equivalent yield, which is an important tool for assessing relative value. We then put this calculation to work by taking a closer look at how recent changes to state and local tax (SALT) deduction rules could factor into relative value. For many investors, curtailment of the SALT deduction will likely make in-state bonds more attractive on an after-tax basis.

Tax-Equivalent Yields

When evaluating a tax-exempt bond, you must go a step further than looking only at the absolute yield. You must also ask: What is the tax-exempt yield worth after you adjust for the tax impact? This is known as the tax-equivalent yield (TEY), and it allows you to consider tax rates when comparing tax-exempt and taxable bonds.
As a reminder, here is the formula to calculate TEY:

Consider two investors, both investing in the same bond offering a 4 percent yield; one in the 24 percent tax bracket and another in the 37 percent. The TEY calculations are as follows:

In other words, the TEY “grosses up” the tax-exempt yield by the individual’s federal tax rate. Of course, all else equal, the TEY will be greater for individuals in higher tax brackets.

Figure 1 compares 10-year bond yields across various investment grade securities. Today, the TEY exceeds the yields on U.S. Treasury or corporate bonds only for investors in the highest tax bracket. By contrast, one year ago the TEY surpassed or nearly equaled the yields on Treasuries or corporates for investors in all tax brackets.

The chart underscores how the relative value between tax-exempt and taxable bonds can change over time. Investors can benefit from closely monitoring price fluctuations across investment grade markets and taking individual tax rates into account.

TEY in Practice

TEYs factor prominently in evaluating the impacts of the new tax rules, which have placed a $10,000 cap on deductions for individuals’ property taxes and state income taxes.1 This stifles a significant federal tax deduction that many taxpayers could take previously.2

For example, consider a California resident that is making $500,000 in annual income, and therefore pays a hypothetical $50,000 in state taxes and maybe $10,000 in property taxes. Prior to the new tax law, that resident could claim a total $60,000 federal deduction. However, now, that resident has only a $10,000 deduction.

Importantly, when investors buy an out-of-state municipal bond they can no longer deduct the state taxes on that bond from their federal taxable income. Therefore, demand for in-state municipal bonds – especially from investors in high-tax states like California, New York and New Jersey – will likely increase.

For example, Figure 2 shows three states with maximum state income tax rates of 13 percent, 9 percent and 3 percent. Prior to the new tax law, if an investor in California purchased an out-of-state municipal bond they would pay a 13 percent tax rate. That tax payment could then be deducted from their federal tax liability. As a result, the effective tax rate on that out-of-state municipal bond was actually 8.2 percent. Under the new tax law the SALT deduction has been limited to $10,000, so the effective tax rate on that same bond is now roughly 13 percent.3 

Using the concept of TEY, we can “gross up” in-state bond yields by the effective tax rates to determine the yield required on an out-of-state bond to achieve the same yield as an in-state bond. After tax reform, the required yield for an out-of-state bond purchase on an after-tax basis has risen--especially for high-tax states and top marginal taxpayers.

For today’s investors, the need to view the tax-exempt market with eyes toward tax efficiency and relative value has become increasingly important for maximizing after-tax, risk-adjusted returns. Of course, TEY is only one of many elements in assessing relative value. In our process, discussed in Managing Shifts in Municipal Relative Value, we closely monitor tax-exempt municipal/Treasury ratios, and if they were to become low or high by historical standards we would look for a different opportunity in a different asset class. For example, if ratios fall very low, it may make sense – even on a TEY basis – to purchase Treasuries and fewer tax-exempt municipals. Relative value should always be assessed with each investor’s tax rate taken into account.


[1] On December 22, 2017, President Donald Trump signed H.R. 1, Tax Cuts and Jobs Bill Act, and H.R. 1370 into law. Taxpayers who itemize will be able to deduct their state individual income, sales and property taxes up to a limit of $10,000 in total starting in 2018. Currently the deduction is unlimited.

[2] The average SALT deduction in the U.S. in 2015 was $12,471 for the 44 million taxpayers who claimed it, according to the Tax Policy Center.

[3] In this example, we assume that the $10,000 is not meaningful in determining the effective tax rate.


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