Suppose that a corporate bond with a Baa credit rating and five years to maturit

Question

Suppose that a corporate bond with a Baa credit rating and five years to maturity has a yield to maturity of 8 percent. Suppose that the government of the city of Udwellum, which has a Baa credit rating, issues a bond with the dame time to maturity in a market that is just as liquid as the market for corporate bonds. Suppose that investors have a federal tax rate of 30 percent. Calculate the interest rate that Udwellum should pay on its bonds if they will yield the same after-tax rate of return to investors as comparable corporate bonds. Show your work.

Explanation / Answer

As the corporate bond interest is subject to tax, the yield will become 8(1-t) = 8*0.7 = 5.6%.

Since Udwellum bonds are tax exempt, they should have an interest rate of 5.6%.

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