Advanced Diploma of Financial Planning (ADFP) Practice Test

What is generally true about pretax yields on taxable instruments in comparison to tax-exempt securities?

1. They are lower than those of tax-exempt securities

2. They are similar in value

3. They are higher than yields for tax-exempt securities with similar risk

4. They are influenced more by market trends

The correct answer is: They are higher than yields for tax-exempt securities with similar risk

The assertion that pretax yields on taxable instruments are generally higher than the yields for tax-exempt securities with similar risk is accurate. This is primarily due to the fact that taxable securities, such as corporate bonds or government bonds, do not benefit from the same tax advantages as tax-exempt securities like municipal bonds. Because investors must pay taxes on the income generated from taxable instruments, those instruments must offer higher yields to attract buyers, compensating them for the tax burden. In essence, the yield on a taxable security needs to exceed the yield on a tax-exempt investment to make it equally attractive to an investor, given that both types of instruments may carry similar levels of risk. This relationship provides a basis for the comparison, as the higher yields of taxable securities reflect the need to account for the taxes owed on the interest earned, while tax-exempt securities offer lower yields but benefit investors by being free from certain taxes. Therefore, when evaluating the yield on both types of securities within their respective contexts, it's clear why pretax yields on taxable instruments would typically be higher than those of similar risk tax-exempt securities.