Tax-Free Yield
The return on a tax-exempt investment such as a municipal bond, not subject to federal income tax.
What is Tax-Free Yield?
Tax-free yield is the stated yield on an investment whose interest income is exempt from federal income taxes — most commonly municipal bonds. Because investors keep the entire stated yield rather than paying taxes on it, a tax-free yield of 3% may be worth more to a high-bracket investor than a taxable yield of 4%. To compare a tax-free yield to a taxable alternative, investors use the tax-equivalent yield (TEY) formula: TEY = Tax-Free Yield ÷ (1 − Marginal Tax Rate). This makes tax-free yield especially attractive to investors in the 32%, 35%, and 37% federal income tax brackets.
Example
An investor in the 37% federal tax bracket comparing a 3.2% municipal bond yield to a 5% corporate bond yield: TEY = 3.2% ÷ (1 − 0.37) = 5.08%. The muni's tax-free yield is actually equivalent to 5.08% taxable — making it marginally better than the 5% corporate bond on an after-tax basis for this investor.