An investor in the 28 percent bracket is trying to decide which of two bonds to

Question

An investor in the 28 percent 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 rate which is selling at par. Assuming the same level of risk for the two bonds, which of these two bonds should the investor select and explain why?

Be sure to incorporate the formula in the text on page 334 at the bottom of the municipal bond section in which the yield on a tax free municipal bond can be converted into an equivalent rate on a taxable bond. Formula on 334 is: Fully taxable equivalant yield= Yield on municipal bond/1- Tax rate

Explanation / Answer

The treasury bond and municipality bond are uncomparable with respect to their return or their characteristics.

So we need to bring them to one line of return,

So the municipality bond return has to be brought to the fully taxable equivalent yield.,

Fully taxable equivalant yield= Yield on municipal bond/1- Tax rate

                                              = 4.25 / 0.72 =5.903%

But where as the Treasury bill gives only 5.5%.

So we can select municipality bond with respect to their returns only,

But if we consider the other factors also then Treasury bond is preferable because there will

Be more guaranty that the return on treasury bill will be paid to investor than the municipality bond because the treasury bond will be assured by US govt.

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