Lesson 2.4: Municipal Bonds Flashcards
The interest from what bonds is exempt from federal income tax?
As defined in the Securities Exchange Act of 1934, Municipal bonds are exempt from federal income tax. Treasury bonds are exempt from state tax but not federal tax. GNMAs are subject to federal, state, and local income tax.
Your client in the 25% federal income tax bracket lives in a state where his earnings place him in the 6% bracket for state income tax purposes. If he were to purchase a 4% bond issued by a political subdivision of his state, his total tax-equivalent yield would be:
slightly more than 5.33%.
When an individual owns a municipal bond issued in his state of residence, not only is the interest tax free on a federal basis but (at least in all cases on the exam) also it is nontaxed in that state. Therefore, the tax-equivalent yield here is slightly higher than it would be if we only computed using the federal tax rate. Because that would be 4.0% divided by 0.75 (100% minus the 25% tax bracket) or 5.33%, saving on state income taxes would increase the yield slightly.
Kate, age 59, has an investment portfolio exceeding $250,000. She considers herself a moderate to conservative investor. To generate additional income, she is anticipating adding bonds to her portfolio. She lives in a state that does not have an income tax and she is in the 28% federal income tax bracket. Which of the following bonds would be the best recommendation for her portfolio?
A) Bond B, BBB rated municipal bond with a 3.75% coupon rate
B) Bond A, A-rated corporate debenture with a 6.50% coupon rate
C) Bond D, AAA rated Treasury note with a 2.55% coupon rate
D) Bond C, CCC rated corporate debenture with an 8.00% coupon rate
B) Bond A, A-rated corporate debenture with a 6.50% coupon rate
Even though Bond C has the highest after-tax rate of return, this bond would not be appropriate for Kate based on her risk tolerance. Therefore, Bond A would be the best choice.
Calculations:
Bond A: 6.5 × (1 – 0.28) = 4.68%
Bond B: 3.75%
Bond C: 8% × (1 – 0.28) = 5.76%
Bond D: 2.55% × (1 – 0.28) = 1.84%
When an investor divides the coupon rate of a municipal bond by the complement of her tax rate, she is computing the bond’s:
tax-equivalent yield.
The computation for the tax-equivalent yield of a municipal bond is performed by dividing the bond’s coupon rate by the complement of the investor’s tax rate (1 – the investor’s tax bracket). If the bond has a coupon of 4% and the investor is in the 20% bracket, the tax-equivalent yield is 4% divided by (1 – 0.20), or 4% divided by 0.80 = 5%.
A client is in the 28% marginal federal income tax bracket and the 3% state income tax bracket. Which of the following investments would produce the highest after-tax yield for the client?
A) An A-rated corporate mortgage bond yielding 8%
B) A public-purpose municipal bond yielding 6%
C) A AAA rated debenture yielding 7.75%
D) A U.S. Treasury note yielding 7%
B) A public-purpose municipal bond yielding 6%
Because your client is in the 28% tax bracket, she has to earn more than the 6% on a taxable bond for the yield to be equal to, or higher than, the tax-free bond. That number can easily be calculated because 72% of the taxable amount must be equal to or greater than the 6% return (6% ÷ 72% = 8.33%). The 8.33% is higher than the return on the other bonds listed, so the public-purpose municipal bond would produce the highest retained return. This would be even more appropriate if the issue was tax exempt in the client’s state.
A client in the 30% tax bracket owns a 5% XYZ, Inc., debenture due to mature shortly. What yield in a municipal bond will result in the same after-tax return that now exists has with the debenture?
The client’s tax rate is 30%; 70% of 5% is 3.5% (5% x 70% = 3.5%). A nontaxable municipal bond with a 3.5% yield would give the client the same return.
An investor in the 28% income tax bracket is considering purchasing either an 8% municipal bond or a 10% corporate bond. What will he do?
The municipal yield is higher than the corporate yield on an after-tax basis.
Investors are interested in their return after taxes (what they get to keep). The two bonds must be compared on a tax-equivalent basis. For example, the tax-equivalent yield of a municipal bond equals tax-free yield divided by 100% minus tax rate. The tax-equivalent rate in this case is 0.08 ÷ 0.72 (100% − 28%) = 11.11%. In other words, a client in the 28% tax bracket would have to invest in a taxable bond that yields 11.11% to get the same after-tax return that the 8% tax-free bond offers.
An investor in the 25% federal income tax bracket is considering the purchase of some fixed-income instruments. Which of the following would provide the investor with the greatest after-tax return?
A) 7% Ba rated corporate bond
B) 4.8% AAA rated insured municipal bond
C) 6% FDIC-insured CD
D) 5% U.S. Treasury bond
A) 7% Ba rated corporate bond
The greatest after-tax return is provided by the instrument listed that, after subtracting 25% for income tax, leaves the investor with the greatest amount. Because the Treasury bond, the CD, and the corporate bond are all taxable at the same rate, the 7% bond must be the best deal. Even though the municipal bond is not taxed, its 4.8% net yield is far lower than the 5.25% ($70 − 25% tax) return on the corporate bond.
Your client in the 28% federal income tax bracket currently owns some U.S. government bonds with a coupon yield of 6%. In order to receive the same income after taxes, she would need to buy municipal bonds with a coupon of
4.32%
Because the 6% on the government bond is fully taxable on a federal basis, the client receives a net of 4.32% ($60 per bond less 28% in taxes [$16.80], or $43.20 per year). Interest on municipal bonds is tax free, so a 4.32% coupon will result in the same amount of after-tax income.
When referring to municipal bonds, the formula of (1 − tax bracket) is found in the computation of:
tax-equivalent yield.
The computation for the tax-equivalent yield of a municipal bond is performed by dividing the bond’s coupon rate by (1 − the investor’s tax bracket). If the bond has a coupon of 4% and the investor is in the 20% bracket, the tax-equivalent yield is 4% divided by (1 − 0.20), or 4% divided by 0.80 = 5%.
Your client in the 25% federal income tax bracket lives in a state where his earnings place him in the 6% bracket for state income tax purposes. If he were to purchase a 4% bond issued by a political subdivision of another state, his total tax-equivalent yield would be
A) 4.00%.
B) approximately 12.90%.
C) slightly less than 5.33%.
D) slightly more than 5.33%.
C) slightly less than 5.33%.
When an individual owns a municipal bond issued in a state other than his state of residence, although the interest is tax free on a federal basis, it is taxable (at least in all cases on the exam) in that state. Therefore, the tax-equivalent yield here is slightly lower than it would be if we only computed using the federal tax rate. Because that would be 4.0% divided by 0.75 (100% minus the 25% tax bracket) or 5.33%, paying the state income taxes would decrease the yield slightly.
A client in the 28% marginal federal income tax bracket invests in a corporate bond with an 8% coupon. To calculate the client’s after-tax rate of return,
multiply 0.08 by 0.72.
To determine a taxable bond’s after-tax rate of return, multiply the coupon rate by the complement of the client’s marginal federal income tax bracket. The client’s tax bracket is 28% (0.28), so the complement is 100% − 28% (1.00 − 0.28) = 0.72.
