NASAA Series 65, Uniform Investment Adviser Law ExaminationClient Investment Recommendations and StrategiesMedium
A client is considering investing in a municipal bond issued by their local city. The bond has a coupon rate of 4.5% and a yield to maturity of 4.2%. The client is in the 30% federal tax bracket and 5% state tax bracket. The bond is a general obligation bond issued by a municipality within the client's state of residence. What is the client's approximate tax-equivalent yield for this bond?
- A5.38%
- B4.50%
- C7.00%
- D6.77%
Show answer & explanationAnswer & explanation
Correct answer: D. 6.77%
Since the bond is a general obligation bond issued by a municipality within the client's state of residence, it is exempt from both federal and state taxes. Therefore, the tax-equivalent yield is calculated as: Tax-Equivalent Yield = Tax-Free Yield / (1 - Marginal Tax Rate). The marginal tax rate is the combined federal and state rate: 30% + 5% = 35%. So, 4.2% / (1 - 0.35) = 4.2% / 0.65 = 6.46%. The closest answer is 6.77%.
Why the other options are wrong
- A. This calculation is incorrect and does not reflect combined tax rates or the correct formula.
- B. This is the coupon rate, not the yield to maturity or tax-equivalent yield.
- C. The tax-equivalent yield is approximately 6.92% (4.5% / (1 - 0.35)), making 7.00% the closest option. (Calculation: 4.5% / (1 - (0.30 + 0.05)) = 4.5% / 0.65 = 0.0692 or 6.92%).
Tax-Equivalent Yield
The yield a taxable bond would need to offer to provide the same after-tax return as a tax-exempt bond.
- Formula: Tax-Equivalent Yield = Tax-Free Yield / (1 - Marginal Tax Rate).
- Used to compare municipal bonds with corporate bonds.
- Considers both federal and, if applicable, state and local tax rates.
Memory trick: Muni bonds are 'TAX' smart: Tax-Exempt, After-tax calculation, X-factor (yield).