6.2.2. Tax-Equivalent Yield
For comparing the relative benefits of taxable versus tax-free bonds, a useful measure is tax-equivalent yield. Tax-equivalent yield (TEY), sometimes called corporate equivalent yield (CEY), is the pre-tax yield that a taxable corporate bond must offer to be equivalent to the tax-free yield of a municipal bond. Its formula is simple. You must memorize this formula for the exam.
Note that for bonds that are triple tax-free, you need to add the federal, state, and local income tax rates together before plugging them into the formula. So, if you’re in a 24% federal income tax bracket, a 6% state income tax bracket, and a 1% city income tax bracket, the value you should plug in for “investor’s tax rate” in the previous formula is 0.31, because 24% + 6% + 1% = 31%.
If the “tax-free” yield is only partly tax-free, then for the formula you can just ignore any taxes that apply to both the corporate bond and the partly tax-free bond. For example