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bracket. All else being the same, would this investor prefer a Aa corporate bond or a Aa municipal bond?

To answer, we need to compare the aftertax yields on the two bonds. Ignoring state and local taxes, the muni pays 4.87 percent on both a pretax and an aftertax basis. The corporate issue pays 6.72 percent before taxes, but it only pays 6.72 X (1 - .30) = .047, or 4.7 percent, once we account for the 30 percent tax bite. Given this, the muni has a better yield.

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Taxable versus Municipal Bonds

Suppose taxable bonds are currently yielding 8 percent, while at the same time, munis of comparable risk and maturity are yielding 6 percent. Which is more attractive to an investor in a 40 percent bracket? What is the break-even tax rate? How do you interpret this rate?

For an investor in a 40 percent tax bracket, a taxable bond yields 8 x (1 - .40) = 4.8 percent after taxes, so the muni is much more attractive. The break-even tax rate is the tax rate at which an investor would be indifferent between a taxable and a nontaxable issue. If we let t * stand for the break-even tax rate, then we can solve for it as follows:

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