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Difficulty: Very hardGovernment, Municipal, and Corporate Bonds

An investor residing in New York is in the 32%32\% federal income tax bracket and an 8%8\% New York state income tax bracket. The investor is evaluating four fixed-income securities trading at par:

- A 5.20%5.20\% municipal bond issued by the State of New York
- A 5.00%5.00\% municipal bond issued by the City of Los Angeles, California
- A 5.50%5.50\% U.S. Treasury note
- A 7.00%7.00\% corporate bond issued by a New York corporation

Which of the following statements correctly identifies the security that offers the highest after-tax yield to this investor?

  1. The 5.20% New York municipal bond, because its interest is fully exempt from both federal and New York state income taxes, resulting in an after-tax yield of 5.20%.Answer
  2. B
    The 5.00% Los Angeles municipal bond, because all municipal bond interest is exempt from federal and state taxes nationwide, delivering an effective yield equivalent to a 7.35% corporate bond.
  3. C
    The 5.50% U.S. Treasury note, because federal government obligations are exempt from federal, state, and local income taxes for all individual taxpayers.
  4. D
    The 7.00% corporate bond, because its higher coupon rate offsets its taxability, yielding an after-tax rate of 4.76% after federal tax deduction.

Answer

The 5.20% New York municipal bond offers the highest after-tax yield at 5.20%.
The statement selecting the 5.20% New York municipal bond is correct because interest earned on municipal bonds issued within an investor's home state is exempt from both federal and state income taxes. Therefore, the investor keeps the entire 5.20% coupon rate.

Step-by-Step Solution

1
Calculate after-tax yield for the New York municipal bond
5.20%
Municipal bonds issued by an investor's home state/city are triple-tax-exempt (free of federal, state, and local tax). Yield remains 5.20%.
2
Calculate after-tax yield for the Los Angeles municipal bond
4.60%
Out-of-state municipal bond interest is free from federal tax (32%) but subject to NY state tax (8%): 5.00%×(1−0.08)=4.60%5.00\% \times (1 - 0.08) = 4.60\%.
3
Calculate after-tax yield for the U.S. Treasury note
3.74%
Treasury debt interest is free from state tax (8%) but subject to federal income tax (32%): 5.50%×(1−0.32)=3.74%5.50\% \times (1 - 0.32) = 3.74\%.
4
Calculate after-tax yield for the Corporate bond
4.20%
Corporate bond interest is fully taxable at both federal (32%) and state (8%) levels, giving a combined tax rate of 40%: 7.00%×(1−0.40)=4.20%7.00\% \times (1 - 0.40) = 4.20\%.
5
Compare all four after-tax yields
NY Municipal (5.20%) > LA Municipal (4.60%) > Corporate (4.20%) > Treasury (3.74%)
The NY municipal bond yields the highest net return after accounting for all applicable tax rules.

Key Concept

Taxability comparison across Government, Municipal, and Corporate debt instruments for state residents.
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Topics

Government, Municipal, and Corporate Bonds

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