Investments, tenth edition

 Table 2.2 

 Equivalent taxable 

yields corresponding 

to various tax-exempt 

yields 

Tax-Exempt Yield

Marginal Tax Rate

1%

2%

3%

4%

5%

20%

1.25%

2.50%

3.75%

5.00%

6.25%

30

1.43

2.86

4.29

5.71

7.14

40

1.67

3.33

5.00

6.67

8.33

50

2.00

4.00

6.00

8.00

10.00

 Figure 2.5 

Ratio of yields on municipal debt to corporate Baa-rated debt  

 Source: Authors’ calculations, using data from   www.federalreserve.gov/releases/h15/data.htm. 

0.5

1953

1956

1959

1962

1965

1968

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

2013

0.6

0.7

Ratio

0.8

0.9

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  C H A P T E R  

2

  Asset Classes and Financial Instruments 

39

yield on Baa-rated corporate debt. The default risk of these corporate and municipal bonds 

may be comparable, but certainly will fluctuate over time. For example, the sharp run-up 

in the ratio in 2011 probably reflects increased concern at the time about the precarious 

financial condition of several states and municipalities.     

  Figure 2.5  shows that in recent years, the ratio of tax-exempt to taxable yields has fluc-

tuated around .70. What does this imply about the cutoff tax bracket above which 

tax-exempt bonds provide higher after-tax yields? Equation 2.3 shows that an inves-

tor whose tax bracket (federal plus local) exceeds 1   2 .70   5   .30, or 30%, will derive 

a greater after-tax yield from municipals. Note, however, that it is difficult to control 

precisely for differences in the risks of these bonds, so the cutoff tax bracket must be 

taken as approximate. 

 Example  2.1 

Taxable versus Tax-Exempt Yields 

 Suppose your tax bracket is 30%. Would you prefer to earn a 6% taxable return 

or a 4% tax-free return? What is the equivalent taxable yield of the 4% tax-free 

yield? 

 CONCEPT CHECK