Question

Imagine you have a choice of buying two bonds. 1) a corporate bond, fully taxable which pays 8% coupon and 2) a tax-exempt municipal bond which pays 6.4% coupon. Your marginal tax rate is 20%. Which bond do you prefer and why?

Answer 1

In order to select a particular bond we need to know the returns that we will receive from the bond.

As corporate bonds are taxable, so the returns from the corporate bonds will be calculated by deducting the tax payable on it.

Municipal bonds are tax exempt, so no tax liability has to be incurred on the income generated from such bonds and the return from the bond will be final returns.

In this case we have choices:

i) Corporate rate bond with 8% coupon rate and marginal tax rate is 20%

After Tax return on corporate bond = Coupon rate * ( 1 - tax rate )

= 8% * ( 1 - 20% )

= 0.08 * 0.80

= 0.064 or 6.40%

So after tax return on corporate bond is 6.40%

ii) Tax - exempt municipal bond with coupon rate of 6.40%

As no tax is deducted on municipal bonds, so the return from the bond is 6.40%

So, if a person invests in Municipal Bonds or the Corporate Bonds which have a face value of $1000, the investor will be entitled to return of $ 64 ( 1000 * 6.4%) from each of the bond during the year.

As both the Municipal Bonds and the Corporate Bonds yield the same return after tax, therefore the person can invest in any of the bonds because he will earn the similar income on both the bonds at the end.

Hope I am able to solve your concern. If you are satisfied hit a thumbs up !!