Question

Explain corporate bond interest in terms of cost of capital versus investor yields. Also, explain the municipal bond interest in terms of investor yields.

Answer 1

Corporate bonds are taxable in the hands of the investor when he receives interest or sells it for profit. On the other hand cost of capital for a firm is the coupon rate paid to the investors after deducting the taxation rate. Ex. A bond issued with a coupon rate of 10%, and tax rate of 30%, has an after tax cost of 10% *(1-30%) =7%. On the other hand the investor yield for the same will be based on his tax rate. If the investor is in a tax bracket of 10%, the investor yield is 10%*(1-10%) = 9%.

In case of municipal bonds, they are tax free for both the issuing entity and the investor. Hence the cost of capital and investor yield will be same i.e. 10% as in our example above.