How do you compare municipal bond yields to taxable bonds? I keep getting tax-equivalent yield wrong.

Municipal bonds (munis) are issued by state and local governments, and their interest is typically exempt from federal income tax (and sometimes state/local tax too). To compare them fairly with taxable bonds, you need the tax-equivalent yield (TEY).

Formula:

Tax-Equivalent Yield = Muni Yield / (1 - Marginal Tax Rate)

Example:

Sophia is in the 37% federal tax bracket. She's comparing:

• Municipal bond yielding 3.2%
• Corporate bond yielding 4.8%

TEY = 3.2% / (1 - 0.37) = 3.2% / 0.63 = 5.08%

The muni's tax-equivalent yield of 5.08% exceeds the corporate bond's 4.8%, so the muni is the better after-tax deal.

Alternatively, you can convert the taxable yield to an after-tax yield:

After-Tax Yield = Taxable Yield x (1 - Tax Rate)

After-Tax Yield = 4.8% x (1 - 0.37) = 4.8% x 0.63 = 3.024%

Since 3.2% (muni) > 3.024% (corporate after-tax), the muni still wins.

Key considerations:

1. The higher your tax bracket, the more valuable the tax exemption
2. In-state munis may also be exempt from state taxes, boosting the advantage further
3. Munis generally have lower credit risk than equivalent corporate bonds
4. AMT bonds: Some munis are subject to the Alternative Minimum Tax — check this before assuming full exemption

Types of municipal bonds:

• General obligation (GO) bonds: Backed by the full taxing power of the issuer
• Revenue bonds: Backed only by revenue from a specific project (toll road, airport, hospital)

Revenue bonds are generally riskier than GO bonds because they depend on project success rather than broad taxing authority.

Exam tip: Always use the marginal tax rate, not the average tax rate. The exam will often provide both to test whether you pick the right one.

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