How to Compare Yields Before and After Taxes

Direct answer: Between the number on a fixed-income screen and the money that ends up in your pocket sit three conversions, and skipping any one of them can flip a decision. The first turns a quote into dollars, because most fixed-income quotes aren't prices. The second puts yields into common units, because different markets build their rates on different calendars. The third subtracts taxes at the right rate, because a pre-tax return is not something you can spend. Here is each one, with the arithmetic.

Turning a quote into dollars#

Start with Treasury bills, government debt of a year or less. Bills pay no coupon; there's no time for scheduled interest payments. You buy below face value, redeem at face value, and the gap is your interest, which is why the quote is a discount rather than a price. A bill quoted at 1.868 isn't selling for $1.87 or $1,868. It's selling at a 1.868% annualized discount from face value.

Turning that into a price is one line of arithmetic: scale the discount by days to maturity over a 360-day year, then subtract from par. For $10,000 of face value with 100 days to run, 10,000 × (1 − 0.01868 × 100/360) comes to $9,948.11. Hold the bill to maturity and you collect the $51.89 difference. That's the entire cash-flow story of a T-bill.

The table lists two such quotes per bill, a bid and an ask. You buy at the ask and sell at the bid, and the bid is always the worse deal for you, because the spread between the two is how the market maker gets paid. Since a bigger discount means a lower dollar price, the bid on a T-bill table shows the larger number of the pair. And when a screen displays a single price, it's usually the midpoint, a number at which nobody will actually trade with you.

Bonds, the longer-term side of fixed income, use a different non-price convention: percentage of par. A bond quoted at 147.023 trades at 147.023% of its $1,000 par value, or $1,470.23. Coupons are percentages of par too: a 6.25% coupon pays $62.50 a year no matter what you paid for the bond. And since most bonds change hands long before maturity, the return on one combines those coupons with the price change at sale, which makes holding a bond behave more like holding a stock than most people expect.

Putting yields on the same calendar#

The second conversion exists because finance never agreed on the length of a year. Money markets annualize over 360 days, a habit surviving from when interest was worked out by hand and a year divisible by 2, 3, 4, 6, and 12 saved real labor. Bond yield math uses 365. Equity desks count 252, the number of trading days. Every annualized rate silently carries its home market's calendar, so rates from different markets can't be compared as printed.

The same bill shows the size of the problem. At $10,000 of face value, 90 days to maturity, priced at $9,900, the money market's discount yield measures the $100 gap against face value over 360 days: 4.00%. The bond equivalent yield measures the same gap against the $9,900 actually paid, over 365 days: 4.10%. The effective annual yield adds compounding: 4.16%. One bill, three correct numbers. So a bond offering 4.05% loses to this "4.00%" bill once both sit on a bond-equivalent basis, and differences that size aren't decorative: fixed income runs on basis points, and ten of them on a billion dollars come to about a million a year.

Comparing yields after taxes#

The third conversion is the one that moves the most money for individual investors: taxes. The rule fits in one line — after-tax return equals pre-tax return times one minus your tax rate — and every comparison should pass through it, because the only return you can spend is the after-tax one.

Fixed income makes this urgent because some of it isn't taxed. Municipal bonds, issued by cities and states to finance public projects, are typically exempt from federal income tax and often from state and local tax as well; the exemption is the incentive that gets bridges and transit lines funded. A corporate bond enjoys no such treatment. So a muni and a corporate quoting the same yield are not offering the same money.

Run the numbers at a 32% marginal tax rate. An 8% corporate bond keeps you 8 × (1 − 0.32), which is 5.44%. An 8% muni keeps you the full 8%. For a taxable bond to match that muni, it would need to yield 8 ÷ (1 − 0.32), about 11.76% before tax. The trap isn't comparing 8% to 8%; few people fall for that once they know munis exist. The trap is the 10% corporate against the 8% muni, where the bigger number wins the glance and pays 6.8% after tax.

There's a clean way to find the crossover: the break-even tax rate is one minus the ratio of the two yields. For an 8% muni against a 10% corporate, 1 − 8/10 = 20%. Above a 20% marginal rate the muni pays more; below it, the corporate does. Which means two investors can look at the same pair of bonds, choose differently, and both be right. The answer depends on the bracket the buyer lives in.

One word in that arithmetic is doing heavy lifting: marginal. Your marginal rate is the tax on your next dollar of income, and it differs from your average rate, which blends everything you earned across the brackets you passed through on the way up and comes out lower. Investment decisions use the marginal rate because an investment is always a next dollar; its cash flows land on top of the income you already have, in whatever bracket that top sits. The same logic runs through valuation generally: what matters is the future, incremental dollar, taxed at the rate that dollar will actually face.

None of this stays inside fixed income. Dividends and capital gains carry their own tax treatments, so the after-tax pass applies to equity as well; bonds are simply where skipping it does the most visible damage, since tax-exempt and taxable instruments sit side by side in the same tables. So the full habit, in order: take the quoted number, ask what it represents, turn it into dollars, put competing yields on the same year, and run everything through one minus your marginal rate. The comparison that matters isn't between the numbers on the screen. It's between the amounts that survive the trip into your pocket.