Question

An investor is considering whether to invest in a general obligation municipal bond and a Treasury bond. The annual interest rate on the municipal bond is 4% and that on the Treasury bond is 5%. Assume that both bonds do not carry any risk. Which bond would the investor prefer if his marginal tax rate on interest income is 10%.

		The investor is indifferent between the two bonds
		The Treasury bond
		The municipal bond
		Not enough information is provided

Answer 1

Assume that an investor has invested $100 in both municipal and treasury bonds. So the interest earned on Municipal bond will be

= 100 * 4%

= 4

and on Treasury bond it will be

= 100 * 5%

= 5

There are no tax charged on Municipal bonds, but you need to pay 10% tax on the interest earned on treasury bond, so

Tax = Interest Earned * Tax Rate

= 5 * 10%

= 0.5

Net Interest Reaned on Treasury Bond = Interest Earned - Tax

= 5 - 0.5

= 4.5

So the investor must choose treasury bonds as he is earning more.

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