Question

(BONUS) Q11 - About a municipality bond a. Descibe it and write one advantage / one disadvantage of it. b. A 7% 10-year municipal bond is currently priced to yield 12%. For a taxpayer in the 25% marginal tax bracket, this bond would offer an equivalent taxable yield of. Explain the calculation steps.

Answer 1

Q11:

a.Municipal bonds are issued by the State or Federal government for the construction of projects like bridges, hospitals and schools.

Advantages: Municipal bonds are an extremely safe investment and free from volatility and they are tax free.

Disadvantages : they do not provide protection against inflation. There exits a small degree of default risk.

b. So, the yield on the equivalent taxable bond is :

12% = yield* (1- 0.25)

So, the yield would be : 16%.

So, the equivalent yield on the taxable bond is 16%.

We first find out the (1 - tax rate ), which in our case is 0.75.

Then we divide this by the yield offered on the taxable bond, after which we get the equivalent yield on the tax free bond