Maria Lopez is a wealthy investor who’s looking for a tax shelter. Maria is in the maximum (35%) federal tax bracket and lives in a state with a very high state income tax. (She pays the maximum of 11½% in state income tax.) Maria is currently looking at 2 municipal bonds, both of which are selling at par. One is a AA-rated in-state bond that carries a coupon of 63/8%.
The other is a AA-rated out-of-state bond that carries a 71/8% coupon. Her broker has informed her that comparable fully taxable corporate bonds are currently available with yields of 93/4%.
Alternatively, long Treasuries are now available at yields of 9%. She has $100,000 to invest, and because all the bonds are high-quality issues, she wants to select the one that will give her maximum after-tax returns.
a. Which one of the 4 bonds should she buy?
b. Rank the 4 bonds (from best to worst) in terms of their taxable equivalent yields.