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Question

Difficulty: MediumGovernment, Municipal, and Corporate Bonds

An investor in a 28%28\% federal marginal income tax bracket purchases a corporate bond at par (1,000)withastatedcouponrateof1,000) with a stated coupon rate of 7.50\%$. What is the investor's after-tax yield on this bond?

Answer: 5.4 %

Answer

The investor's after-tax yield on the corporate bond is 5.40%.
Interest income from corporate bonds is fully taxable at both federal and state levels. To calculate the net return for an investor, the nominal yield must be adjusted by the tax rate: After-Tax Yield=Corporate Yield×(1−Tax Rate)\text{After-Tax Yield} = \text{Corporate Yield} \times (1 - \text{Tax Rate}). For a 7.50%7.50\% coupon bond held by an investor in a 28%28\% tax bracket, the calculation is 7.50%×(1−0.28)=5.40%7.50\% \times (1 - 0.28) = 5.40\%.

Step-by-Step Solution

1
Identify the nominal corporate yield and tax rate.
Pre-tax corporate yield = 7.50%7.50\%, Federal tax rate = 28%28\%.
Corporate bonds pay interest that is fully subject to federal marginal income tax.
2
Set up the after-tax yield equation.
After-Tax Yield=Pre-Tax Yield×(1−Tax Rate)\text{After-Tax Yield} = \text{Pre-Tax Yield} \times (1 - \text{Tax Rate})
The investor retains the portion of interest income remaining after income tax is deducted.
3
Perform the multiplication.
7.50%×(1−0.28)=7.50%×0.72=5.40%7.50\% \times (1 - 0.28) = 7.50\% \times 0.72 = 5.40\%.
Multiplying the pre-tax return by the net retained percentage (72%) yields the net return.

Key Concept

Corporate Bond After-Tax Yield
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Topics

Government, Municipal, and Corporate Bonds

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