Municipal Debt

Question 1

A customer purchases 3M of Chicago Water Authority 9% revenue bonds maturing in 2042 at 87. The interest payments are Mar 15th and Sept 15th. The trade took place on Tuesday, April 15th. How much accrued interest will the customer be required to pay the seller?

A. $8
B. $9
C. $24
D. $27

Answer 1

The best answer is C.

The trade took place on Tuesday, April 15th and settles 2 business days after trade date on Thursday, April 17th. Interest accrues from the morning of the last interest payment up to, but not including, settlement, calculated on a 30 day month / 360 day year basis. The last interest payment was made on March 15th. Interest accrues from March 15th through March 30th, so there are 16 days that must be counted for in March; and continues until the settlement date of April 17th, so an additional 16 days of accrued interest must be paid for April. The total number of days is 16 for March + 16 for April = 32 days of accrued interest due.

32 Days Interest x $90 x 3 Bonds
————————————————- = $24
360 Days

Note that “3M” stands for $3,000 face amount of bonds (M is Latin for $1,000).

Question 2

A customer residing in Connecticut that is in the 20% Federal tax bracket and the 5% State tax bracket wishes to make a bond investment with a minimum 10-year life. The customer also wants a high level of safety. The following 10-year bonds are available:

Yield
AAA Corporate Bond	5.50
U.S. Treasury Bond	4.00
AAA Federal Home Loan Bank Bond	4.50
AAA Connecticut Bond	3.50
The best recommendation for the customer is the:

A. U.S. Treasury bond
B. AAA Corporate bond
C. AAA Connecticut bond
D. AAA Federal Home Loan Bank bond

Answer 2

The rules on taxation of interest income received, generally, are:
Treasury/Agency Issues: Interest is subject to Federal Income tax, but is exempt from State and Local tax
Municipal Issues: Interest is exempt from Federal Income tax, and exempt from State and Local tax when purchased by a resident of that state
Corporate Issues: Interest is subject to Federal Income tax, and to State and Local tax

If the customer buys the Treasury bond yielding 4.0%, 20% of the yield will go to the Federal Government, so the after-tax yield is (.8 x 4.00%) = 3.20%.

If the customer buys the Federal Home Loan Bank bond yielding 4.50%, 20% of the yield will go to the Federal Government, so the after-tax yield is (.8 x 4.50%) = 3.60%.

If the customer buys the Corporate bond yielding 5.50%, 20% of the yield will go to the Federal Government and 5% to the State Government, so the after-tax yield is (.75 x 5.50%) = 4.125%.

If the customer buys the Municipal bond yielding 3.50%, there is no tax on the income received at either the Federal or State level, so the after-tax yield is 3.50%.