Final answer:
Interest income from municipal bonds is typically tax-exempt at the federal level, and often at the state and local levels if the bond is issued in the state of residence. With rising interest rates, a bond's market value will decrease to offer a yield competitive with current rates. Investors calculate the present value of the bond's future payments at the new market rate to decide the purchase price.
Step-by-step explanation:
The subject of the question pertains to the taxation of interest income from a municipal bond, specifically an Albany, New York, general obligation bond. However, the example provided in the reference information relates to a hypothetical investment decision involving a local water company's bond and how its value would change with fluctuating interest rates.
Concerning the taxation question, in general, the interest income from municipal bonds issued by a state, municipality, or county is exempt from federal income taxes. If the resident of New York City buying the bond also resides in the state of New York, which issued the Albany bond, then the interest income would also typically be exempt from state and local taxes. However, if the bond were from a different state, it might be subject to state or local taxes in New York.
In the example provided for investment consideration, the local water company issued a $10,000 ten-year bond at a 6% interest rate. If interest rates rise to 9%, one would expect to pay less than the face value of $10,000 for the bond because the current yield (interest rate) is higher than the coupon rate of the bond. The bond's price must decrease to make its effective yield competitive with the current market rate of 9%. The investor would calculate the present value of the bond's future payments (interest and principal) discounted at the new market rate to determine how much to pay for the bond. If the alternative investment offers a return of 12%, indicating a higher available interest rate, the bond would be worth even less than its face value.