Question

State whether you agree or disagree with the statement below. Explain you answer.

"If the highest marginal income tax rate increases, yields of tax-exempt municipal bonds should increase relative to yields of taxable corporate bonds, all else equal."

Hint: Would tax-exempt bonds become more or less attractive to investors in the highest tax brackets when these investors start getting taxed at higher rates? If a tax benefit of Investing in a tax-exempt security increases, would investors be willing to accept a lower before-tax yield on such a security?

Answer 1

Yes I agree for above statement, It's important to briefly look at taxing entities and their ability to issue various forms of debt. While municipalities have the potential to issue muni bonds in both taxable and tax-exempt forms. Investors usually place their bets on tax exempt muni issues for the obvious tax benefits. Meanwhile, investors in taxable municipal debt always seek a higher yield (also known as a tax -equivalent yield) on their investments to compensate for the tax burden.