An investor in the 28% tax bracket is trying to decide which of two bonds to select: one is a 5.5% U.S. Treasury bond selling at par; the other is a municipal bond with a 4.25% coupon, which is also selling at par. Which of these two bonds should the investor select? Why?

To determine which bond the investor should select, we need to compare the after-tax yield of each bond.

For the U.S. Treasury bond, the coupon rate is 5.5%. Since it is a U.S. Treasury bond, the interest income is subject to federal income tax but is exempt from state and local taxes.

For the municipal bond, the coupon rate is 4.25%, and since it is a municipal bond, the interest income is typically exempt from federal income tax and may also be exempt from state and local taxes.

Since the investor is in the 28% tax bracket, they will have to pay 28% on the interest income from the U.S. Treasury bond.

Let's calculate the after-tax yield of each bond:

For the U.S. Treasury bond:
After-tax yield = Coupon rate * (1 - Tax rate)
After-tax yield = 5.5% * (1 - 0.28)
After-tax yield = 3.96%

For the municipal bond:
The interest income from the municipal bond is typically exempt from federal income tax. If it is also exempt from state and local taxes, the after-tax yield will be the same as the coupon rate:

After-tax yield = 4.25%

Comparing the after-tax yields, the U.S. Treasury bond has an after-tax yield of 3.96%, while the municipal bond has an after-tax yield of 4.25%.

Therefore, the investor should select the municipal bond with a 4.25% coupon rate since it offers a higher after-tax yield compared to the U.S. Treasury bond.

To determine which bond the investor should select, we need to compare the after-tax yields of both bonds and consider the investor's tax bracket.

Let's calculate the after-tax yields for both bonds in order to make a comparison:

1. U.S. Treasury Bond:
The bond has a 5.5% coupon rate, which means it pays an annual interest of 5.5% of its face value. Since it is selling at par, its yield is equal to its coupon rate.

2. Municipal Bond:
The bond has a 4.25% coupon rate, similar to the U.S. Treasury bond. However, since it is a municipal bond, the interest earned from it is typically exempt from federal taxes. Therefore, the after-tax yield is equal to the coupon rate.

Now, let's calculate the after-tax yield for each bond given the investor's 28% tax bracket:

1. U.S. Treasury Bond (after-tax yield):
Since the investor is in the 28% tax bracket, the after-tax yield can be calculated by subtracting the tax rate from 100% and multiplying it by the coupon rate:

After-tax yield = (1 - tax rate) * coupon rate
= (1 - 0.28) * 5.5%
= 0.72 * 5.5%
= 3.96%

2. Municipal Bond (after-tax yield):
Since the interest earned from municipal bonds is generally exempt from federal taxes, there is no need to calculate an after-tax yield in this case. The after-tax yield remains equal to the coupon rate of 4.25%.

Based on the comparison of after-tax yields, the investor should select the municipal bond with a 4.25% coupon. This is because the after-tax yield on the municipal bond (4.25%) exceeds the after-tax yield on the U.S. Treasury bond (3.96%). By choosing the municipal bond, the investor can earn a higher after-tax return on investment.