Examkin

Question

Difficulty: HardGovernment, Municipal, and Corporate Bonds

A financial registered representative is evaluating fixed-income debt securities for an investor who resides in Ohio and is in a high federal income tax bracket. The representative presents four statements comparing the taxability and risk profiles of U.S. Treasury, municipal, and corporate bonds. Which of the following statements correctly describes the tax treatment or risk characteristics of these debt securities?

  1. Interest income generated by a municipal bond issued by a municipality in California is exempt from federal income taxes, but is subject to state income taxation for an Ohio resident.Answer
  2. B
    Interest income from a municipal bond issued by a municipality in California is exempt from all federal, state, and local income taxes for any investor regardless of their state of residence.
  3. C
    When prevailing market interest rates rise, an existing fixed-rate corporate bond's market price increases while its yield to maturity decreases to adjust to new market conditions.
  4. D
    United States Treasury bonds carry no market risk because they are backed by the full faith and credit of the federal government.

Answer

Interest income generated by an out-of-state municipal bond is exempt from federal income taxation, but is subject to state and local income taxes for a resident of another state.
Interest income from municipal bonds is exempt from federal income taxation under tax law. However, individual states generally grant state tax exemption only to residents who purchase municipal debt issued within their own state. Therefore, an Ohio resident purchasing a California municipal bond receives federal tax exemption but must pay Ohio state income tax on the interest income.

Step-by-Step Solution

1
Analyze federal vs. state tax rules for municipal debt instruments.
Interest earned on municipal bonds is exempt from federal income tax. However, state tax exemption typically requires the investor to reside in the state (or U.S. territory) where the bond was issued.
States tax interest income from out-of-state municipal obligations while exempting interest from in-state municipal obligations.
2
Evaluate the taxability of a California municipal bond held by an Ohio resident.
The Ohio resident receives federal tax exemption, but must pay Ohio state income tax on the interest earned from the California municipal bond.
Out-of-state municipal bonds do not qualify for state tax exemption.
3
Differentiate credit risk from market risk for U.S. Treasury debt.
U.S. Treasury securities are free of default/credit risk due to federal backing, but long-term Treasury bonds still fluctuate in price when interest rates change, exposing investors to market/interest rate risk.
Government backing guarantees principal and interest payments, not price stability in secondary markets.

Key Concept

Taxability of Municipal Bonds across State Lines and Bond Risk Characteristics
Rate this question

Topics

Government, Municipal, and Corporate Bonds

More questions from this topic