Premium Muni vs. Corporate Bond
Lena, 68, is in the 35% federal bracket and 6% state bracket. She is considering a 10-year in-state municipal bond with a 3.10% coupon, priced at 104.50, callable in three years at par; its yield to maturity is 2.55%, and its yield to worst is 2.10%. The alternative is a 10-year noncallable corporate bond yielding 5.40%. Lena's state taxes corporate interest but exempts in-state municipals. She needs $25,000 of after-tax income annually from a $600,000 bond allocation and wants 'the highest safe income.' She says she does not understand why anyone would buy a 3.10% muni when a 5.40% corporate is available.
1. Compute the tax-equivalent yield of the municipal bond using the coupon, the yield to maturity, and the yield to worst. Compare those results with the corporate bond on an after-tax basis.
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Lena's combined marginal rate is not simply 35% + 6%; state tax is deductible against federal, so the combined rate is 35% + 6%(1 - 0.35) = 38.9%. The municipal bond is in-state, so both federal and state tax are avoided. Tax-equivalent yield = muni yield / (1 - 0.389). Using the 3.10% coupon: 3.10 / 0.611 = 5.07%. Using the 2.55% yield to maturity: 2.55 / 0.611 = 4.17%. Using the 2.10% yield to worst: 2.10 / 0.611 = 3.44%. The corporate bond's after-tax yield is 5.40% × (1 - 0.389) = 3.30%. So on a coupon basis the muni is competitive, but on a yield-to-worst basis it is not. The corporate bond's after-tax yield of 3.30% exceeds the muni's 2.10% worst-case yield. The premium price matters: at 104.50, Lena pays $627,000 for $600,000 of par value, and if the bond is called at par in three years she loses the $27,000 premium, which is already reflected in the 2.10% yield to worst.
2. Assess whether either bond meets Lena's $25,000 after-tax income target and discuss the call risk.
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At a 3.10% coupon, $600,000 of the muni produces $18,600 of tax-free income. The corporate bond produces $32,400 pre-tax and $32,400 × 0.611 = $19,796 after tax. Neither meets the $25,000 target. To generate $25,000 after tax from the muni coupon, Lena would need about $25,000 / 0.031 = $806,000 of par value; from the corporate bond, about $25,000 / 0.033 = $758,000. The call risk makes the muni less attractive than the coupon suggests. If rates fall, the issuer likely calls the bond at par in three years, leaving Lena with reinvestment risk and a realized loss of the premium. If rates rise, the bond may not be called, but its price will fall. The yield-to-worst of 2.10% is the more conservative planning number. A noncallable bond, a discount muni, or a laddered portfolio would give Lena more predictable income.
3. What bond features and client facts would change your recommendation?
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Features that would improve the muni case include a lower premium price, a later or more favorable call schedule, a higher coupon with a shorter maturity, and strong credit quality. A discount muni avoids premium-call loss and may offer better tax-adjusted value. On the client side, if Lena's state tax rate were higher, or if she were subject to the alternative minimum tax on private-activity munis, the comparison would change. If she values safety over yield, a high-quality noncallable muni or a Treasury ladder may be preferable to the corporate. If she can accept credit risk, a diversified corporate bond fund or ladder could close the income gap. Her $25,000 target should be addressed directly: either accept a lower income level, allocate more than $600,000, or blend taxable and tax-exempt bonds rather than forcing the muni to do all the work.