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Series 7 practice questionmediumDebt Securities — Municipal Bonds — Taxable Equivalent Yield Scenario

An investor in the 24% tax bracket is comparing a 3.5% municipal bond with a 4.5% corporate bond. Which provides the better after-tax return?

  1. AThe municipal bond, with a TEY of 4.61%✓ Correct answer
  2. BThe corporate bond, with an after-tax yield of 3.42%
  3. CThey provide the same after-tax return
  4. DCannot be determined without knowing the maturity
Explanation

Why A — The municipal bond, with a TEY of 4.61%

The municipal bond's taxable equivalent yield is 3.5% / (1 - 0.24) = 3.5% / 0.76 = 4.61%. The corporate bond's after-tax yield is 4.5% x (1 - 0.24) = 4.5% x 0.76 = 3.42%. Since 4.61% > 4.5%, the municipal bond provides a better equivalent return. Alternatively, the municipal bond's 3.5% tax-free yield exceeds the corporate bond's 3.42% after-tax yield.

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