Question

An investor is attempting to decide between the purchase of a tax-free municipal bond or a corporate bond. She is in the 32% tax bracket (rate). A municipal bond yields 2.2% interest and a corporate bond yields 3.1% interest. Which should she purchase? Please state the reason.

Answer 1

Tax-free municipal bond are the bonds which are exempt from any tax on the other hand corporate bonds are the bonds on which tax is applicable, so in order to know which investment is beneficial for the investor we need to calculate the after tax yield of the bonds.

As muncipal bonds are tax free so the yield of muncipal bonds will remain the same before and after tax

After tax yield on Municipal Bonds = 2.20%

Yield on Corporate bonds before tax = 3.10%

Tax rate = 32%

After tax yield on corporate bonds = Yield on Corporate bonds before tax * ( 1 - Tax rate )

= 3.10 * ( 1 - 32% )

= 3.10 * 0.68

= 2.11%

So, the after tax yield on Municipal Bonds is 2.20% which is greater than that on Corporate bonds which is 2.11%. Therefore purchasing municipal bonds will be beneficial for the investor

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