Question

You can invest in either a corporate bond which yield 4.85%, or a municipal bond (of equal risk) which yield 3.43%.  Which investment should you choose?

Ignore state income taxes:

         A. Your marginal personal tax rate is 35%

B. Your marginal personal tax rate is 14%

Please show your calculation for each investor from (Muni to Corporate bond, and once again, from Corporate to Muni bond equivalent interest rates). In other words,

your calculations will cover two different situations for parts A & again for B; for a total of 4 different sets of calculations.

Answer 1

Municipal Bonds are Tax free bonds.The municipal bond market is currently offering after-tax yields comparable to corporate bonds,

Part A
Personal marginal Tax Rate @35%
Particulars	Corporate Bond	Municipal Bond
Yield	4.85%	3.43%
Tax Rate	35%	Nil
Effective Yield	3.1525%	3.43%

Part B
Personal marginal Tax Rate @14%
Particulars	Corporate Bond	Municipal Bond
Yield	4.85%	3.43%
Tax Rate	14%	Nil
Effective Yield	4.1710%	3.43%

Municipal bonds are preferred to those individuals who are in higher tax brackets. Therefore if we have marginal Tax Rate as 35% municipal bonds should be preferred, and of we have tax rate as 14% we should prefer the corporate bond.