Final answer:
The Johnsons are focusing on after-tax returns on their bond investments. Municipal bonds yield 3.5%, which they keep entirely due to their tax-exempt status, and taxable bonds have a 5% return, reduced to 3% after taxes. The municipal bonds offer a better after-tax return for the Johnsons.
Step-by-step explanation:
Comparing After-Tax Returns on Different Bonds:
The Johnsons recently decided to invest in municipal bonds, which provide a return on municipal bonds at 3.5 percent. Since their marginal tax rate is 40 percent, these bonds are attractive as they are generally exempt from federal taxes. This yield is directly theirs to keep. In contrast, the return on similar taxable bonds is 5 percent, but this would be subject to their 40 percent tax rate.
To compare the after-tax returns, we need to calculate the effective return on the taxable bonds after applying the tax rate of 40 percent. The after-tax return of the taxable bond is calculated as 5 percent * (1 - 0.40), which gives us 3 percent. Therefore, the municipal bonds offer a higher after-tax return for the Johnsons at 3.5 percent, compared to the after-tax return of the taxable bonds at 3 percent.
Bonds can fluctuate in value based on changes in interest rates. For example, if interest rates increase, existing bonds with lower rates become less valuable and sell for less than face value. The opposite is true when interest rates decrease. Nonetheless, the Johnsons are focusing primarily on the interest income, and tax-exempt municipal bonds offer them a better after-tax yield due to their high marginal tax rate.