The yield on a one-year corporate bond is 8.6% and the yield on a one-year municipal bond is 5.75%. If the bonds have the same default risk and the marginal tax rate is 33%, which bond is preferable?

Question

The yield on a one-year corporate bond is 8.6% and the yield on a one-year municipal bond is 5.75%.  If the bonds have the same default risk and the marginal tax rate is 33%, which bond is preferable?

Quizplus · Accepted Answer

The after-tax yield of the corporate bond is calculated as its yield multiplied by (1 - tax rate), which is 8.6% * (1 - 0.33) = 5.762%. Since the municipal bond's interest is not taxable and its yield is 5.75%, the corporate bond's after-tax yield is slightly higher, making it the preferable option.

The Yield on a One-Year Corporate Bond Is 8