A municipal bond has a yield of 6% while a corporate bond yields 7 percent. If you are in the 30 percent tax bracket, which bond would you prefer to buy and why? At what tax rate would you be indifferent between these two bond yields?

I would prefer to buy municipal bond as it offers more income than corporate bond in terms of net income in the hands of investor. Although interest rate on corporate bond is high but tax exemption of municipal bonds make it more attractive investment alternative. Incremental income in the hands of investor would be $ 11 i.e., ($ 60 - $ 49).

Tax rate of 14.29% would be indifferent between these two bond yields.

Step-by-step explanation

Municipal bonds are tax exempt i.e., there is no taxation of interest received from municipal bonds. Whereas on the other hand, interest income received from corporate bond is fully taxable.

Let face value of municipal bonds and corporate bond be $ 1000 each.

Interest rate on municipal bond = 6 %

Interest rate on corporate bond = 7 %

Tax rate = 30%

Interest on municipal bond = face value * interest rate

= $ 1,000 * 6 %

= $ 60

Interest on corporate bond = face value * interest rate * (1 - tax)

= $ 1,000 * 7 % * (1 - 0.30)

= $ 49

I would prefer to buy municipal bond as it offers more income than corporate bond in terms of net income in the hands of investor. Although interest rate on corporate bond is high but tax exemption of municipal bonds make it more attractive investment alternative.

Let tax rate be t for purpose of computing indifference point between these two bond yields.

Interest on corporate bond * ( 1 - tax ) = Interest on municipal bond

70 * ( 1 - t ) = 60

t = 1 - (60 / 70)

t = 1 - 0.8571

t = 0.1429 or 14.29%

Tax rate of 14.29% would be indifferent between these two bond yields.

Note: Intermediate calculations has been rounded off to four decimal places and final answer has been rounded off to two decimal places.