Question

The Sampsons- A continuing Case: Chapter 16

The Sampsons are considering investing in bonds as a way of saving for their children's college education. They learn that there are bonds with maturities between twelve and sixteen years, which is exactly when they need the funds for college expenses. Dave and Sharon notice that some highly rated municipal bonds offer a coupon rate of 2%, while some highly rated corporate bonds occur at a coupon rate of 4%. The Income on the municipal bonds would not be subject to federal income tax. Dave and Sharon are looking to you to advise on whether bonds are a sound investment.
1. If the Sampsons decide to purchase bonds, should they invest in corporate bonds or municipal bonds? FACTOR INTO YOUR ANALYSIS THE RETURN THEY WOULD RECEIVE.

Answer 1

The Sampsons should compare the after-tax yield of corporate bonds to the tax-free yield of municipal bonds when deciding which to invest in for college savings, considering their tax bracket and the risks associated with corporate bonds.

Step-by-step explanation:

Investing in Bonds for College Savings

When the Sampsons are choosing between investing in municipal bonds and corporate bonds, they should consider the after-tax return on their investment. Although municipal bonds offer a lower coupon rate of 2%, this interest is not subject to federal income taxes. On the other hand, corporate bonds offer a higher coupon rate of 4%, but this income is taxable. If Dave and Sharon are in a higher tax bracket, the taxable equivalent yield on the municipal bonds may actually be greater than the yield on the corporate bonds after accounting for taxes.

Corporate bonds are considered riskier than government bonds, leading to a higher interest rate, as firms are riskier borrowers. However, highly rated corporate bonds and Treasury bonds interest rates tend to rise and fall together, indicating a correlation in their market interest rate movements. Nevertheless, the key difference here is the tax treatment. To make an informed decision, Dave and Sharon need to compare the net return on corporate bonds after taxes to the return on municipal bonds.

Moreover, if interest rates rise, bonds issued at lower rates sell for less than face value. Conversely, if interest rates fall, bonds with higher rates will sell for more. For example, if buying a bond with a face value of $1,000 and a coupon rate of 8% when market rates are at 9%, the price of the bond will be below its face value, making its yield higher than the coupon rate.

Answer 2

The Sampsons should invest in municipal bonds because, despite a lower coupon rate of 2%, the tax-free status of municipal bond income makes the after-tax return more favorable compared to corporate bonds, offering a higher tax-adjusted return.

Step-by-step explanation:

Municipal bonds are the more favorable option for the Sampsons due to their tax advantages. Although municipal bonds offer a lower coupon rate of 2%, the income generated is not subject to federal income tax. On the other hand, corporate bonds may provide a higher coupon rate of 4%, but the interest earned is taxable. To determine the effective return, it is essential to consider the after-tax return. Let's calculate the after-tax return for both types of bonds using the formula:

`\[ \text{After-Tax Return} = \text{Coupon Rate} * (1 - \text{Tax Rate}) \]`

For municipal bonds with a coupon rate of 2% and no federal income tax, the after-tax return remains at 2%. For corporate bonds with a coupon rate of 4%, assuming a hypothetical federal income tax rate of 25%, the after-tax return is calculated as:

`\[ \text{After-Tax Return} = \text{Coupon Rate} * (1 - \text{Tax Rate}) \]`

Comparing the after-tax returns, municipal bonds offer a better tax-adjusted return of 2% compared to the after-tax return of 3% for corporate bonds. Considering the tax advantages, the Sampsons should opt for municipal bonds to maximize their investment returns for their children's college education fund.