Question

Considering two types of bonds for cilents investment portfolio. The first instrument is a fully taxable corporate bond offering a 9.5% annual rate of return. The second instrument is a municipal bond issued. This bond is paying a 6.75% annual rate of return. Assume also that your client has the following tax rates: Federal tax level: 25% State tax level: 3% Local tax level: 2% A. If your client lives in an area and has triple tax free status, what would the after-tax return your client would get if he/she were to invest in the corporate bond? which bond would you recommend to your client, the municipal or the corporate?

Answer 1

Answer-

The Corporate bond annual rate of return = 9.5 %

As the Coporate bond is taxed fully we have to apply all taxes at Federal, State and Local level

Federal tax = 25 %
State tax = 3 %
Local tax = 2 %

After tax return on Corporate bond

After tax return = 9.5 % x ( 1 - 25 %) x ( 1 - 3 %) x ( 1 - 2 %)

After tax return = 9.5 % x ( 1 - 0.25) x ( 1 - 0.03) x ( 1 - 0.02)

After tax return = 9.5 % x (0.75) x (0.97) x (0.98)

After tax return = 6.773 %

The return on Corporate bond after taxes = 6.773 %

The return on Municipal bond = 6.75 % [ it is triple tax free status ]

As the after tax return on Corporate bond ( 6.773 %) is more than the return on Municipal bond ( 6.75 %) therefore the client is recommended to take Corporate bond in his portfolio.

Corporate bond should be selected as it has more return than Municipal bond.