FINRA Series 7Investment Information and Suitable RecommendationsHard
A client, aged 45, is in the 30% federal income tax bracket and 5% state income tax bracket. They are considering a municipal bond with a 4.0% coupon rate and a corporate bond with a 5.5% coupon rate. Which bond offers a better after-tax yield for this client?
- AThe corporate bond, as its after-tax yield is 3.575%.
- BThe municipal bond, as its tax-equivalent yield is 7.27%.
- CThe municipal bond, as its tax-equivalent yield is 6.15%.
- DThe corporate bond, as its after-tax yield is 5.5%.
Show answer & explanationAnswer & explanation
Correct answer: C. The municipal bond, as its tax-equivalent yield is 6.15%.
To compare a municipal bond (tax-exempt) with a corporate bond (taxable), calculate the Taxable Equivalent Yield (TEY) for the municipal bond. The client's combined tax rate is needed for this calculation.
Why the other options are wrong
- A. This correctly calculates the after-tax yield for the corporate bond but doesn't compare it to the correct TEY for the municipal bond.
- B. This uses an incorrect combined tax rate or formula for TEY.
- D. This incorrectly assumes the corporate bond's coupon rate is its after-tax yield, ignoring taxes.
Taxable Equivalent Yield (TEY)
The Taxable Equivalent Yield (TEY) is used to compare the yield of a tax-exempt municipal bond to that of a taxable bond. It represents the yield a taxable bond would need to offer to match the after-tax return of a municipal bond.
- TEY = Municipal Bond Yield / (1 - Investor's Combined Tax Rate).
- Combined Tax Rate = Federal Rate + State Rate (if applicable, and not deductible from federal).
- Used for comparing municipal bonds with corporate bonds or other taxable investments.
Memory trick: Tax-free munis need a 'TEY' lens to truly compare.