Question

Maria is a wealthy investor who’s looking for a tax shelter. Maria is in the maximum (35%) federal tax bracket and lives in a state with a very high state income tax. (She pays the maximum of 10% in state income tax.) Maria is currently looking at two municipal bonds, both of which are selling at par. One is a AA-rated, in-state bond that carries a coupon of 6%. The other is a AA-rated, out-of-state bond that carries a 7% coupon. Her broker has informed her that comparable fully taxable corporate bonds are currently available with yields of 10%. a. What are the tax-adjusted yields of the two municipal bonds? b. Which one of the three bonds should she buy?

Answer 1

a. Federal Tax rate: 35%

State Tax rate: 10%

Taxable equivalent yield on the 3 bonds available is as follows:

1. In State Municipal bond yield:

In State bond will be tax free both within state and fedral level.

Tax rate to be used here would be = 35% + 10% = 45%

AA rated coupon = 6%

Tax Equivalent Bond Yield on In-State Municipal Bond: 6%/ (1- (0.35 + 0.1) = 13.333%

2. Out of State Bond yield:

Out of State Bond will be tax free at federal level but not state level.

Tax rate to be used here = 35%

AA rated out of state bond coupon: 7%

Tax Equivalent Bond Yield on Out of State Municipal Bond : 7%/ (1-0.35) = 10.769%

3. Taxable corporate bond yield: 10%

b. Higher the tax equivalent bond yield, the better it is.

Maria should buy In state AA rate bond to get best returns.

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