Problema Solution
An investor in the 28% tax bracket is trying to decide which of two bonds to select: one is a 5.5% U.S. Treasury bond selling at par; the other is a municipal bond with a 4.25% coupon, which is also selling at par. Which of these two bonds should the investor select? Why?
Answer provided by our tutors
The treasury bond yields 5.5%, but the investor only keeps 100 - 28 = 72% of this, bringing the yield down to 0.055*0.72 = 0.0396 or 3.96%.
The municipal bond yields 4.25% tax free.
So it depends on the investor's objectives.
If he/she wants the higher return they will pick the municipal bond, however if the investor wants a totally safe investment with a zero chance of loosing money or suffering through a default, they will sacrifice the higher return and pick treasury bond since is 100% backed by the full faith and credit of the US government.