What is Yield Equivalence?

Yield equivalence has to do with the balance that is required between the yield that is achieved on a taxable investment and the amount realized on the tax-free return that is offered on a bond. Sometimes referred to as an equivalent taxable yield, the concept behind the yield equivalence is to create a situation where amount of profit that is made from an investment that is subject to tax is balanced out by the profit that is achieved by the bond. By doing so, the overall impact of the tax payment on the investor is minimized.

Monitoring the yield equivalence within this type of arrangement involves making appropriate choices in the selection of municipal bonds and on other types of investments that are subject to taxes. Ideally, the yield on the bond will be sufficient to cover the taxes that are assessed for the taxable investment and still make a small amount of profit. This use of the tax-exempt yield helps to keep the overall worth of the investment portfolio stable.

By creating this type of yield equivalence, the investor also enjoys a couple of other advantages. First, the use of the yield from the municipal bond helps to cover the applicable taxes, which in turn frees other financial resources to be used with other investments. Second, the offset helps to maintain a balance between low risk investments and other types, since a bond is considered to be a low risk investment. Last, the predictable nature of the municipal bond makes it possible for the investor to make projections on the future performance of the complete portfolio, using these stable elements to get a good idea of the minimal amount of return that can be expected.

Because market conditions can change quickly with investments that are not as stable a municipal bonds, the ratio of yield equivalence within an individual portfolio will shift when market conditions shift. When market indicators predict a shift that will impact several securities within the portfolio, it is a good idea to calculate the yield equivalence that would be present if the predictions come true. By doing so, the investor can make decisions of what to buy or sell in order to maintain a desired rate of yield equivalence.