Friday, February 28, 2014

How to Calculate Tax-Equivalent Yield for a Series 7 Question

When an investor has found two 10-year bonds, both rated A-, should she invest in the 6% tax-free municipal bond or the 8% taxable corporate bond?
The answer depends entirely on her marginal tax rate. A test question could go something like this . . .

When deciding between a 6% tax-free bond and an 8% taxable bond, at which marginal bracket does an investment in the tax-free bond become advantageous?
A. 20%
B. 25%
C. 30%
D. 33%

In order to figure out the tax rate that first makes the 6% bond more attractive, you''ll have to keep taking the .06 the bond pays and divide it by .80, then, .75, then .70, and maybe even .67 until the tax-equivalent yield ends up higher than 8%. What happens when we take .06 divided by .75? We get a tax-equivalent yield of .08, which is exactly the same as what the corporate bond offers. Not surprisingly, when we take .06 and divide it by .70 (30% marginal bracket), we find that the tax-equivalent yield is now 8.57%, making C our answer. Yes, at 33% the investor should also be buying the municipal bond, but the question asked at which bracket the yield begins to rise above 8%. As always, the Series 7 expects you to do more than memorize a few terms and try a few little tricks to fudge your way through it.Pass your Series 7

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