Question

An investor in the 35 percent tax bracket may purchase a corporate bond that is rated A and yields 6.0 percent. The investor may also buy an A-rated municipal bond with a 3.9 percent yield. Why may the corporate bond be preferred? (Assume that the terms of the bonds are the same.)

Answer 1

The after tax yields are the same for both bonds. Possible reasons for preferring the corporate bond to the muni bond:

a) The corporate bond is almost surely more liquid than the muni bond as it is traded on an exchange and the muni bond isn't. That's very helpful if you want to get your money out of the bond.

b) The investor believes that there is a significant chance that his income tax bracket will drop making the after-tax yield of the corporate bond better than the muni bond.

c) The investor fears a blow up in the muni bond market as the recession destroys the tax base upon which the muni bonds rely for coupon payments.

d) The investor likes cash-in-hand/pay taxes later rather than tax free income.