Question

A. What are the tax risks associated with municipal bonds?

B. What is the equivalent taxable yield for an investor with a 35% marginal tax rate who could buy a tax-exempt municipal bond with a yield of of 8.5%?

C. Why might the equivalent taxable yield be limited in how it measures the relative value of a tax-exempt bond versus a taxable bond?

Answer 1

Municipal Bonds are debt securities which are issued by government entities. There are many risks associated with municipal bonds like Credit risk, Call risk etc. Similarly Tax implications are also there.. As interest rate is less than may be less than that of fully taxable bonds, but may provide greater returns after the tax is taken into account but that doesn't means that these are free from all tax implications. The interest that is earned on tax exempt obligations can be included in the current earnings for the purpose of corporate Federal alternate min tax. Some are not tax exempted and they have separate market of municipal issues that are taxable but still offers local exemption or interest paid to residents of the state of issuance.

Equivalent taxable yield = Tax free Municipal Bond yields/ (1- Tax rate)

= 8.5%/(1-35%)

= 13.07% approximately

becoz..When computing the equivalent taxable yield, the computed yield to maturity is not the tax-exempt yield if the issue is selling at a discount because only the coupon interest is exempt from federal income taxes. instead the yield to maturity after an assumed tax rate on the capital gain is computed and used in the numerator of the formula that computes the equivalent taxable yield.And also u must realize that the effects of other taxes can also pose problem when comparing tax- exempt bonds verses taxable bonds.becoz the yield on municipal bonds is less than that on treasuries with the same maturity.