Bond comparison and taxation Peter Clemenza and Luca Brasi are arguing about the

Question

Bond comparison and taxation

Peter Clemenza and Luca Brasi are arguing about the following bonds. Both bonds are for 5 years, each with the par value of $100,000. The coupon rates are compounded semi-annually. The coupon rate for bond #1 (favored by Mr. Clemenza) equals 1.8% and is tax free. The coupon rate for bond #2 (favored by Mr. Brasi) equals 2.6%, but it is subject to both federal and state taxes. The combination of federal and state taxes on this type of bonds usually average to about 30%. Peter Clemenza argues that since one does not have to pay taxes on bond #1, then it is a better investment. Luca Brasi says the bond #2 is a good investment, because it will earn higher return than the bond #1. Can you settle their argument? Which bond would you recommend?

Explanation / Answer

Assuming that the bond is selling at par

after tax return on 1 = 1.80% since it is tax free

after tax return on 2 = 2.6*(1 - 0.3)% = 1.82%

so Bond 2 is better

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