Final answer:
To compare a tax-exempt municipal bond with a taxable corporate bond, an investor must calculate the tax-equivalent yield, which for a client in the 33% tax bracket with a 5.80% municipal bond yield would be 8.66%. The corporate bond would need to provide a higher yield to be considered a better investment after taxes for this client.
Step-by-step explanation:
The question presented concerns the comparison of yields between a municipal bond and a corporate bond for a client in a specific tax bracket, to determine which investment is more advantageous after taxes. This involves understanding the concept of tax-equivalent yield—the pretax yield that a taxable bond needs to possess for its yield to be equal to that of a tax-exempt bond.
Corporate bonds typically have higher yields compared to government bonds, compensating for their higher risk. The interest from municipal bonds is usually exempt from federal taxes, and sometimes state and local taxes, making them particularly appealing to investors in higher tax brackets. To compare the two bond types, investors must calculate the tax-equivalent yield of the municipal bond by using their marginal tax rate. This allows for an apples-to-apples comparison between the tax-free municipal bond and the taxable corporate bond.
For a taxpayer in the 33% tax bracket comparing a 5.80% municipal bond yield to a corporate bond, the formula for the tax-equivalent yield is as follows: Municipal Bond Yield / (1 - Marginal Tax Rate). Inserting the numbers, we have 5.80% / (1 - 0.33) = 8.66%.
Therefore, for the municipal bond to be preferred over the corporate bond, the corporate bond would need to offer a yield higher than 8.66%.