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
Assume that an investor has invested $100 in both municipal and treasury bonds. So the interest earned on Municipal bond will be
= 100 * 4%
and on Treasury bond it will be
= 100 * 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%
Net Interest Reaned on Treasury Bond = Interest Earned - Tax
= 5 - 0.5
So the investor must choose treasury bonds as he is earning more.
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