Question

Assume a corporate bond is paying an annual coupon of 7%. A municipality bond with the same level of risk and the same time to maturity is paying 6% annual coupon. Your tax rate is 20%, which bond would you prefer to invest in? What would be the tax rate that would make you indifferent between the two investments? (Muni bond, 14.3%)

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Answer 1

The interest payment payment on corporate bond is not tax deductible. Hence, tax will be paid on interest received on corporate bonds. However, interest received on municipal bonds are tax exempt i.e. no tax is paid on interest received on such bonds

After tax return on corporate bond = 7%(1-20%) = 5.6%

After tax return on Municipal Bond = 6%

Hence. municipal bond is preferable.

Let the tax rate be x

7%(1-x) = 6%

x = 14.285%

i.e. 14.3%

Hence, tax rate at indifference point = 14.3%