Question

Cliff Clarkson is 70 years old and wants to diversify his investment portfolio. He must decide if he should invest in tax-free municipal bonds or in corporate bonds. The tax-free bonds are highly rated and pay 4.5%. The corporate bonds are more speculative and pay 6.5%

a. If Cliff is in the 25% tax bracket, what is the advantage in choosing the municipal bond?

b. If you were Cliff, would you choose the municipal bonds or the corporate bonds? Justify your answer.

Answer 1

a) If Cliff is in 25% tax bracket, his net yield in the corporate bond will be =6.5%*(1-25%) =4.875%, there is a benefit of 0.375% in choosing corporate bond. But the corporate bond is speculative and its yield would most likely be fluctuating very often, whereas municipal bond is AAA bond with a high rating, it is deemed to be stable and offer a stable return to the investor.

b) If I were Cliff, I would prefer municipal bond, this is due to the fact that Cliff's age is 70, he is most probably retired and would require a consistent income to live, this need would be best served by a highly rated bond rather than a fluctuating yield highly risky bond.