Question

A municipal bond yields 6.75%.

A corporate bond on comparable credit quality and maturity yields 9.0%.

At what marginal tax rate would an investor be indifferent between the two bonds?

Based on your answer, explain why investors in the highest tax-bracket are more inclined to invest in municipal bonds than investors in lowest tax-bracket.

Answer 1

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.

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

So, here the investor will be indifferent between the two bonds if the returns from both the bonds after tax are same.

If we look at tax - exempt municipal bond with coupon rate of 6.75%

As no tax is deducted on municipal bonds, so the return from the bond is 6.75%

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 $ 67.5 ( 1000 * 6.75%) from the bond during the year.

In order to be indifferent the after tax return from the bond should be same, so the marginal tax rate which will give similar return is:

= (Corporate Bond Yield - Municipal Bond Yield) / Corporate Bond Yield

= ( 9 - 6.75 ) / 9

= 0.25 or 25%

So, if the Marginal tax rate is 25% then the investor would be indifferent between the two bonds.

Investors in the highest tax-bracket are more inclined to invest in municipal bonds than investors in lowest tax-bracket as the municipal bonds are tax exempt and also they are more secured bonds as compared to the corporate bonds.

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