.An investor in the 28 percent tax bracket is trying to decide which of two bonds to select: one is a 5.5 percent U. S. Treasury bond selling at par; the other is a municipal bond with a 4.25 percent coupon, which is also selling at par. Which of these two bonds should the investor select? Why?
A U.S. Treasury bond is taxable. The municipal bond is not taxable.
Do the math.
To determine which bond the investor should select, we need to compare the after-tax yield of each bond. Here's how we can calculate it:
1. Calculate the after-tax yield of the U.S. Treasury bond:
- Given yield on the U.S. Treasury bond = 5.5%
- Investor's tax bracket = 28%
- Substract the tax savings from the yield by multiplying the yield by (1 - tax bracket):
After-tax yield = 5.5% * (1 - 0.28) = 5.5% * 0.72 = 3.96%
2. Calculate the after-tax yield of the municipal bond:
- Given coupon rate on the municipal bond = 4.25%
- Municipal bonds are typically exempt from federal income tax, so there is no need to adjust for taxes:
After-tax yield = 4.25%
Comparing the after-tax yields, we see that the after-tax yield of the treasury bond is 3.96%, while the after-tax yield of the municipal bond is 4.25%.
Since the after-tax yield of the municipal bond (4.25%) is higher than that of the U.S. Treasury bond (3.96%), the investor should select the municipal bond. The municipal bond provides a higher after-tax return, making it the more attractive choice for an investor in the 28% tax bracket.