Future Business Leaders of America (FBLA) Securities and Investments Practice Test

Tax-equivalent yield is useful for comparing what?

1. Taxable and tax-exempt investments

2. Certain corporate bonds only

3. Different investment strategies

4. Investment durations only

The correct answer is: Taxable and tax-exempt investments

Tax-equivalent yield is a valuable metric primarily used for comparing taxable investments with tax-exempt investments, such as municipal bonds. The importance of this comparison lies in the fact that different investments may generate different levels of returns, influenced by the tax implications associated with them. Tax-exempt securities, like municipal bonds, yield interest that is not subject to federal income tax, making their effective return potentially more attractive to investors in higher tax brackets. The tax-equivalent yield allows investors to convert the tax-exempt yield into an equivalent taxable yield, making it easier to assess whether a tax-exempt investment is more favorable than a taxable one. For example, if an investor is comparing a municipal bond with a yield of 3% to a corporate bond yielding 4%, the investor needs to consider their specific tax situation to accurately compare these returns. By calculating the tax-equivalent yield, the investor can determine what unknown taxable interest rate would provide them with the same after-tax income as the municipal bond does. This metric does not serve the purpose for comparing corporate bonds specifically, different investment strategies, or variations in investment durations, as these factors involve distinct considerations that are not directly related to the effects of taxation on yield.