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Difficulty: HardGovernment, Municipal, and Corporate Bonds

An investor subject to a 35% federal marginal income tax rate and a 5% state marginal income tax rate purchases a newly issued in-state municipal bond at par with a yield of 3.90%. What fully taxable corporate bond yield would provide the investor with the exact same after-tax yield?

Answer: 6.5 %

Answer

6.50%
Because in-state municipal bond interest is exempt from both federal and state income taxes, the investor avoids a combined marginal tax rate of 40% (35% federal + 5% state). Dividing the municipal yield of 3.90% by (1 - 0.40) gives 6.50%, representing the corporate bond yield required to deliver the same net after-tax return.

Step-by-Step Solution

1
Calculate the combined tax exemption rate
40% (0.40)
In-state municipal bonds are exempt from both federal (35%) and state (5%) income taxes, making the combined tax rate 40%.
2
Apply the Tax-Equivalent Yield formula
Tax-Equivalent Yield = 3.90% / (1 - 0.40)
To determine the fully taxable yield needed to match a tax-exempt municipal yield, divide the municipal yield by one minus the investor's total marginal tax rate.
3
Compute the final equivalent corporate yield
6.50%
Dividing 3.90% by 0.60 results in 6.50%.

Key Concept

Tax-Equivalent Yield for Municipal Bonds
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Topics

Government, Municipal, and Corporate Bonds

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