Question

Interpret the following statement made by Wall Street analysts and portfolio managers: “Although yields among bonds are related, today’s rumors of a tax cut caused an increase in the yield on municipal bonds, while the yield on corporate bonds declined.”

Answer 1

Interest payment on debt is considered as expense for company. So, company can deduct interest expense from taxable income. So, company need to pay lesser tax because of debt capital. So total cost of debt become lower because of tax rate.

Interest income of Municiple is exempted from any taxation. it mean the investor does not need to pay tax on interest income on municiple bond but on corporate bond comapny need to pay tax as per normal tax slab rate.

Now, if tax cut that is tax rate reduce then tax shiedl on debt capital also reduces, so yield on corporate bonds declined to make after tax cost of debt unchanged. Similarly yield on municipal bonds increases to make total income unchnaged.