Question

Suppose there are two types of investors in the municipal bond market. The interest on municipal bonds is tax free. 40% of the participants pay a 30% tax rate and 60% pay a 15% tax rate. Consider the following bond:

Price of bond = $1000

Interest payment on bond = $40

Interest payment on a similar bond with the same price that is not tax free = $55

1. Which, if any, type of investor should choose the municipal bond over the taxable bond? Explain.

Answer 1

Answer:

Municipal bonds- These are debt securities, issued by state and local Government and return is free from taxes.

Taxable bonds- As the name suggests, these bonds are the debt securities whose return is subject to income tax.

Investors have different risk profile, taste, return needs and tax brackets. Choosing the bond depends upon the size of the tax bill. If an investor is under 30% income tax bracket and lives in the state of higher taxes then he will invest into municipal bonds, by investing into municipal bond, he will get lower return but that is tax free so we have to see the "After tax yield".

On the other hand, if an investor is in 15% tax bracket, he will not buy municipal bonds rather will buy the taxable bond. Tax exempt municipal bonds are popular in those who have higher tax brackets.