Final answer:
If the Johnsons are considering after-tax returns, they should purchase municipal bonds as their after-tax return from taxable bonds is 3 percent, which is less than the 3.5 percent from municipal bonds. In a market where interest rates have increased, such as from 6% to 9%, bonds issued at the lower rate are sold at a discount to their face value.
Step-by-step explanation:
Assuming the Johnson's marginal rate is 40 percent, their after-tax rate of return from taxable bonds would be 3 percent (5 percent x (1-.40)). Since this return is less than the 3.5 percent rate of return from municipal bonds, it would be financially beneficial for the Johnsons to purchase municipal bonds. The after-tax yield of taxable bonds is important in investment decisions, especially when compared to tax-exempt securities like municipal bonds.
When deciding between different types of bonds, one must consider the current interest rates and how they affect the price and yield of bonds. A local water company’s bond with a 6% coupon, for instance, will be less attractive in a market where interest rates have risen to 9%. This is because new bonds are likely being issued at the higher rate, making the older bonds with lower interest rates less valuable.
Investors typically pay less than the face value for bonds in such a scenario because they can get a higher interest rate elsewhere. Therefore, you would expect to pay less than the $10,000 face value for a bond that's paying 6% when the market rate is 9%. The exact price you’d be willing to pay would depend on the new market yields and the remaining time to maturity, but it will certainly be below the par value (face value) of the bond.