Imagine that a long-term municipal bond selling at par is yielding 4.21 percent while a long-term Treasury
Question:
Imagine that a long-term municipal bond selling at par is yielding 4.21 percent while a long-term Treasury bond selling at par yields 6.07 percent.2 Further suppose an investor is in the 24 percent tax bracket. Ignoring any difference in default risk, would the investor prefer the Treasury bond or the muni?
To answer, we need to compare the aftertax yields on the two bonds. Ignoring state and local taxes, the muni pays 4.21 percent on both a pretax and an aftertax basis. The Treasury issue pays 6.07 percent before taxes, but it pays .0607 × ( 1 − .24 ) = .0461, or 4.61 percent, once we account for the 24 percent tax bite. Given this, the Treasury bond still has a better yield.
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Corporate Finance
ISBN: 9781265533199
13th International Edition
Authors: Stephen Ross, Randolph Westerfield, Jeffrey Jaffe