Question

Ye Yuan is in retirement and is considering investing in one of the following two money market securities:

A US Treasury Bill offering 6.95%
A Massachusetts Municipal bond offering 4.78%

Ye pays Federal tax at the rate of 26% and tax to the state of Massachusetts (his state residency) of 5%.

Ye estimates that the US Treasury Bill has zero risk of default, and that the Massachusetts municipal bond has a 1% chance of default.

Because the quoted yield is before tax and credit risk adjustments, Ye is interested in determining which of these two bonds is best. How much more (or less) in yield does the Treasury Bill offer after adjusting for tax and credit risk? If the believe that the Treasury Bill is best, then enter the differential as a positive number. If you believe the municipal is best, then enter the differential as a negative number.

Difference in yield =  %

Answer 1

Municipal bond offer tax-free interest. Accounting for credit risk, yield on municipal bond = Yield x (1 - default chance) = 4.78% x (1 - 1%) = 4.7322%

After-tax yield on US treasury = Yield x (1 - tax rate) = 6.95% x (1 - 26%) = 5.143

Hence, the US treasury offers a higher rate.

Difference = 5.143% - 4.7322% = 0.4108%