Explain corporate bond interest in terms of cost of capital versus investor yields. Also, explain the municipal bond interest in terms of investor yields.

yield and cost are same in quantum but different in nature. cost of bond capital(Kd) has two components (1) coupon cost and redemption cost(2)

I.e. Kd = C + R

Where

R = redemption cost = (face value - price)/price

C = coupon cost.

This cost Kd shows at what cost the debt capital can be rasied

This cost Kd is simply the yield (Y) for the investors, which is given by,

Y = Cy + G

Where,

G = redemption gain or capital gain = (face value - price)/price

Cy = coupon yield of bond

It shows that on quantitative basis both yield and cost are same and this very logical because company will raise debt funds at a rate which is agreed upon by the investors.

Now the difference between these two is that post tax and cost and post tax yield are different in quantity also because the corporate rax rates and personal tax rates are different.

Let us understand this with the help of an example,

A company issues 1 year $1000 par value bonds at 10% coupon rates and the price paid by the investors was 900. Corporate tax rate is 30% and personal tax for investors is 10%

Now, the gross cost to company is Kd = 0.10 + (1000 -900)/900 = 0.2111 or 21.11%

Post tax cost or Kd* = 21.11* (1- .30) = 14.78%

Gross yield to investors = 0.10 +(1000-900)/900 = .21111 or 21.11%

Post tax yield = 21.11% * (1-0.10) = 18.99%

This was a basic example however the bond yield depends on various factors like

Credit default risk

Illiquidity risk

Mmaturity risk

Iinflation risk

Higher these risk, higher will be premium demanded by the investors resultingly yield will also be high.

Mmunicipal bonds are simply the bonds issued by municipalities of the states. Now we know that the credit default risk of municipalities is lower than that of corporates or any private organisation but higher than that of fedral government hence the yield of municipal bonds are lower than those of corporate bonds but higher than treasuries yield and that too the yields of municipal bonds are exempt from both fedral as well as concerned state tax. This way municipal bonds provide a perfect balance to a portfolio. And like other govt bonds these majorly deep discount bonds.