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Difficulty: HardGovernment, Municipal, and Corporate Bonds

An investor residing in California is subject to a 37%37\% federal marginal income tax rate and a 13%13\% California state income tax rate. The investor is evaluating an in-state California municipal bond offering a yield of 4.25%4.25\%, which is exempt from both federal and state income taxes. What is the tax-equivalent yield (expressed as a percentage) that a fully taxable corporate bond must offer to match the after-tax yield of this municipal bond?

Answer: 8.5 %

Answer

The tax-equivalent yield required from a fully taxable corporate bond is 8.50%8.50\%.
Municipal bonds issued within an investor's resident state are exempt from both federal and state income taxes (double tax-exempt). The investor's total effective tax rate for this comparison is 37%+13%=50%37\% + 13\% = 50\%. Using the tax-equivalent yield formula TEY=Municipal Yield1−Combined Tax Rate\text{TEY} = \frac{\text{Municipal Yield}}{1 - \text{Combined Tax Rate}}, we calculate 4.25%1−0.50=4.25%0.50=8.50%\frac{4.25\%}{1 - 0.50} = \frac{4.25\%}{0.50} = 8.50\%. A fully taxable corporate bond must yield 8.50%8.50\% to equal the 4.25%4.25\% net payout of the municipal bond.

Step-by-Step Solution

1
Calculate the combined tax bracket for double-exempt income.
Combined tax rate = 37%+13%=50%37\% + 13\% = 50\% (or 0.500.50).
Municipal bonds issued by the investor's state of residence provide double tax exemption from both federal and state income taxes.
2
Apply the tax-equivalent yield formula for a double-exempt bond.
Tax-Equivalent Yield=4.25%1−0.50=4.25%0.50=8.50%\text{Tax-Equivalent Yield} = \frac{4.25\%}{1 - 0.50} = \frac{4.25\%}{0.50} = 8.50\%.
To determine what pre-tax corporate yield equals the net municipal yield, divide the tax-free yield by (1−Combined Tax Rate)(1 - \text{Combined Tax Rate}).

Key Concept

Tax-Equivalent Yield for Double Tax-Exempt Municipal Bonds
Estimated Time:2m 0s
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Topics

Government, Municipal, and Corporate Bonds

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