Question

A client is trying to decide between a par value corporate bond carrying a coupon rate of 6.25% per year and a par value municipal bond that pays an annual coupon rate of 4.75%. Assuming all other factors are equal, and your client is in a 28% marginal income tax bracket, which bond do you tell the client to purchase and why

Answer 1

Answer:

Municipal bond

Explanation:

We can clearly find out which bond to select by finding their equivalent taxable yield.

DATA

Coupon rate (corporate bond) = 6.25%

Coupon rate (municipal bond) = 4.75%

Marginal income tax = 28%

Equivalent taxable yield of municipal bond = coupon / (1-tax rate)

Equivalent taxable yield of municipal bond = 4.75% / (1-0.28)

Equivalent taxable yield of municipal bond =  6.6%

Hence municipal bond must be selected having a higher equivalent taxable yield as compared to corporate bond.