Tax-equivalent yield (TEY) is a calculation that converts the yield on a tax-exempt bond to the yield a taxable bond would need to offer to provide the same after-tax income. The formula is straightforward: TEY equals the tax-free yield divided by one minus your combined marginal tax rate. This comparison is essential because a 3.5% tax-free municipal bond can be worth more than a 5% taxable corporate bond depending on your tax bracket.

The value of tax-exempt income increases with your tax rate. An investor in the 37% federal bracket gets far more benefit from tax-free income than someone in the 12% bracket. For high-income investors, municipal bonds often provide a superior after-tax return compared to taxable alternatives, even though their stated yields appear lower. State tax exemption adds further value if you invest in munis issued by your home state.

Keep in mind that tax-equivalent yield is just one factor in bond selection. Credit quality, duration, liquidity, and call provisions all matter. Municipal bonds are generally very safe, with default rates historically far below corporate bonds, but individual issue analysis is still important. Also note that while municipal bond interest is federally tax-exempt, it may still be subject to the alternative minimum tax (AMT) on certain private activity bonds.