Question

An investor in the 28 percent tax bracket is trying to decide which of two bonds to purchase. One is a corporate bond carrying an 8 percent coupon and selling at par. The other is a municipal bond with a 5½ percent coupon, and it, too, sells at par. Assuming all other relevant factors are equal, which bond should the investor select?

Answer 1

Step-by-step explanation:

If a coupon paying bond is selling at par value, it means that the yield to maturity (YTM) is equal to the coupon rate.Therefore, these bonds have the following YTMs;

Pretax;

Corporate bond's YTM = 8%

Municipal bond's YTM = 5.5%

With regard to taxes, corporate bonds interests are not tax-exempt whereas municipal bond interests are.

Therefore,

After tax YTM = ; Pretax rate(1-tax)

Corporate bond = 0.08(1-0.28) = 0.0576 or 5.76%

Municipal bond ; will remain the same = 5.5%

The investor should select the corporate bond as it offers a higher after tax yield than the Municipal bond.