yield equivalence
Yield equivalence is the maths that converts a tax free return into the taxable return you would need to earn the same money in your pocket.
In plain English
Why does that government savings bond advertise a lower rate than the corporate bond next to it, yet people still say the government one pays better?
That is the question yield equivalence answers, and once you see it, you stop comparing interest rates the lazy way, by just looking at the biggest number.
Some investments come with tax breaks, and some do not, so a rate on its own tells you nothing until you ask what you actually keep after tax.
Say a Nigerian professional in London finds a tax free bond paying 4 percent, and a normal savings account paying 5 percent but taxed at 20 percent.
The 5 percent account only nets 4 percent after tax, so it is actually equal to the tax free bond, not better than it, even though 5 sounds bigger than 4.
That equal point is the yield equivalence, the taxable rate that matches a tax free rate once you strip out what the tax man takes.
Back home, this same thinking helps someone compare a Federal Government bond with certain tax advantages against a corporate bond with a higher headline rate but no such shelter.
The person sending money to family in Lagos while investing abroad benefits most from this idea, because it stops them chasing the flashiest percentage sign and helps them chase the flashiest outcome instead.
A tax free instrument pays 6 percent. If your tax rate is 25 percent, you would need a taxable investment paying 8 percent to end up with the same amount in hand, since 8 percent minus 25 percent tax lands you back at 6 percent.
Questions people ask
Is yield equivalence only useful for bonds?
It is most common with bonds, especially government ones with tax perks, but the same idea applies anywhere one option is taxed differently from another, including certain savings accounts and mutual funds.
Do I need to calculate this myself?
Many bond calculators and financial advisers will do it for you, but knowing the idea means you can question a rate that looks impressive until you ask what tax will calmly remove from it.
Does this apply to Nigerian investments too?
Yes, whenever you are choosing between an instrument with a tax exemption, like certain government securities, and one without, you should work out the equivalent taxable yield before deciding which pays you more.
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