Question

Presidential administrations often like to "tinker" with the tax code. Assume the tax code under former President O'Bomba listed the highest marginal tax rate at 40% and that President Chump reduced the marginal rate 30%, Which scenario below describes the most likely impact this change in tax policy will have on municipal and corporate bonds.

A. The after-tax yield on corporate bonds for investors in the highest tax bracket will be lower due to the reduction in the top tax rate.

B. Both muni and corporate bond yields will remain unchanged as a result of the new tax policy. Investors in the top tax bracket will always favor muni-bonds over corporate regardless of changes in the highest marginal tax rate.

C. Both muni and corporate bond yields will remain unchanged. Investors in the top tax bracket will buy more munis to save even more taxes.

D. The tax cut causes an increase in the after-tax yield on corporate bonds. In response, muni bond yields would rise (prices fall) to make them equally attractive as the after-tax yields on corporate bonds for investors in the top tax bracket.

Answer 1

Option D is correct reason. The lowering of tax will result in increase in after tax yield for corporate bonds and yield on Municipal bonds will remain unchanged (as these are tax free bonds). Hence the investor will attract more towards Corporate bonds. So to make muni bonds equally attractive, its yield has to be increased.

Option A is incorrect as it says after tax yield on Corporate bond will reduce due to lowering of tax.

Option B and C are incorrect as it says after tax yield will remain unchanged for Corporate bond yields.