Final answer:
An investor must assess the after-tax yield for both short-term municipal bonds and taxable bonds to determine which is more favorable. Municipal bonds may offer tax-exempt interest, while the higher nominal yield of taxable bonds is reduced by the investor's tax rate. Calculating after-tax yield and comparing can reveal the best option.
Step-by-step explanation:
The question involves comparing the after-tax yields of different types of bonds for an investor in a certain tax bracket. To determine which bond gives the higher after-tax yield between short-term municipal bonds and comparable taxable bonds, one must assess the impact of taxes on the interest earned from each bond.
Municipal bonds are often tax-exempt, meaning the interest they generate may not be subject to federal income taxes. This can make them particularly attractive to investors in higher tax brackets. In contrast, interest from taxable bonds is subject to federal (and sometimes state) income taxes. Therefore, the after-tax yield is lower than the stated interest rate once the tax impact is accounted for.
To calculate the after-tax yield for a taxable bond, you can use the formula: After-tax yield = interest rate × (1 - tax rate). Then, one would compare the after-tax yield of the taxable bond with the yield of the municipal bond to determine which investment is more favorable. One must remember that the higher nominal interest rate of the taxable bond does not necessarily translate into a greater after-tax return, especially for investors in high tax brackets.