An investor in the 28% tax bracket is trying to decide which of two bonds to select: one is a 6.5% U.S. Treasury Bond selling at par; the other is a municipal bond with a 5.25% coupon, which is selling at par. Which of these two bonds should the investor select? Why?
To determine which bond the investor should select, let's compare the after-tax returns of both bonds.
1. U.S. Treasury Bond:
- Coupon rate: 6.5%
- Taxable at the federal level (28% tax bracket)
To calculate the after-tax return, apply the tax rate to the coupon rate:
After-tax return = Coupon rate * (1 - Tax rate)
After-tax return = 6.5% * (1 - 0.28) = 4.68%
2. Municipal Bond:
- Coupon rate: 5.25%
- Municipal bonds are exempt from federal taxes
In the case of municipal bonds, the coupon rate already represents the after-tax return since they are exempt from federal taxes.
Comparing the after-tax returns:
- U.S. Treasury Bond: 4.68%
- Municipal Bond: 5.25%
Based on the comparison, the investor should select the municipal bond. Despite having a slightly lower coupon rate, it offers a higher after-tax return. This is because the interest from municipal bonds is exempt from federal taxes, providing a tax advantage for investors in higher tax brackets.
To determine which bond the investor should select, we need to compare the after-tax returns of both bonds.
Let's start by calculating the after-tax return of the U.S. Treasury Bond. The bond has a coupon rate of 6.5%, which means it will pay $6.50 of interest per year for every $100 par value. Since it is selling at par, the investor will receive the full $6.50 interest payment.
Since the investor is in the 28% tax bracket, they will have to pay 28% of the $6.50 interest as taxes. Therefore, the after-tax return of the U.S. Treasury Bond can be calculated as follows:
After-tax return = (1 - Tax rate) * Coupon rate
After-tax return = (1 - 0.28) * 6.5%
After-tax return = 0.72 * 6.5%
After-tax return = 4.68%
Now let's calculate the after-tax return of the municipal bond. The bond has a coupon rate of 5.25%, which means it will pay $5.25 of interest per year for every $100 par value. Again, since it is selling at par, the investor will receive the full $5.25 interest payment.
One advantage of municipal bonds is that the interest income is usually tax-exempt at the federal level and sometimes at the state or local level as well. Therefore, the after-tax return of the municipal bond in this case is equal to the coupon rate:
After-tax return = Coupon rate
After-tax return = 5.25%
Comparing the after-tax returns, we can see that the after-tax return of the U.S. Treasury Bond is 4.68%, while the after-tax return of the municipal bond is 5.25%. Therefore, the investor should select the municipal bond because it offers a higher after-tax return.
However, it's important to note that individual tax situations can vary, and there may be additional factors to consider, such as state or local taxes. Therefore, it is recommended for the investor to consult with a financial advisor or tax professional to make an informed decision based on their specific circumstances.