When investing, it is fundamental for the investor to make a comparison of various investment opportunities and determine which investment promises a higher return while ensuring that risks are as low as possible. The analysis sometimes requires a thorough examination of elements associated with types of investments. In this regard, it would be essential to take into consideration coupon rates, period of maturity and other features attached to both corporate bonds and municipal bonds. In this scenario, Beth Anaheim is attempting to consider choosing an investment opportunity. Corporate bonds are commonly subjected to federal taxes while municipal bonds are provided with tax exemptions (Stan, 2009).
The DES corporate bond, which is rated as A, would be offered at the corporate rate of 9% and would mature after a period of 7 years. It would be as well be subjected to a combined federal and state marginal tax rate of 30%. On the other hand, the FGR municipal bond rated as AAA would be offered at a coupon rate of 7% whilst its maturity period is 7 years, similar to that of DES corporate bond. With these figures and imperative explanation relating to the two bonds at hand, we would be in a position to give a justification of why municipal bonds stand a greater chance of providing Beth Anaheim with higher returns in addition to ensuring a low level of risks as compared to corporate bond (Wesalo, 2001).
In order to make this analysis more understandable, it would be necessary to come up with a formula that endeavors to compare returns at both corporate bond municipal bond levels. The formula is as stated below:
R (m) = R(c) [1-t]
Where:
- R (m) = interest rate of municipal bond
- R (c) = interest bond of corporate bond
- t= tax rate
Let us now consider which coupon rate of the corporate bond is comparable to a coupon rate of 7% of a municipal bond.
R(c) =R (m)/ [1-t]
With this formula at hand, we should get the corporate bond coupon rate as:
- R(c) =7/ [1-0.3]
- R (c) =10%
This means that the holder of a municipal bond earning a coupon rate of 7% could only be equated to a holder of a corporate bond subjected to a coupon rate of 10%. It, therefore, means that with the availability of municipal bond, which is issued at a coupon rate of 7%, one should not accept any corporate bond offered at a coupon rate of less than 10% given that corporate bonds are subjected to combined federal and state marginal tax rates of 30% (Hubbard, 2007).
Given that the coupon rate of DES corporate bond is 9% and a combined federal and state marginal tax rate is 30%, it would be wise to choose tax-free municipal bond issued at the rate of 7% since it yields an interest rate compared to a corporate bond that could have been issued at the rate of 10%. This decision should be essential to undertake considering the two bonds have a similar maturity period of 7 years.
In addition, it is wise to understand the risks of default associated with the two bonds (Shan, McGuin, & Waller, 2007). It is generally recognized that municipal bonds are associated with low levels of defaulting risks as compared to other types of bonds such as municipal bonds. In the year 2007, the Standard & Poor 500 Index rated municipal bonds of AAA rating with a defaulting chance of 0.0% while corporate bonds of ‘A’ rating were stated to have a defaulting rate of 2.9%. It, therefore, becomes vital for Beth Anaheim to prefer FGR municipal bond as his investment opportunity as opposed to choosing DES corporate bond (Anand, 2007).
References
Anand, S. (2007). Optimizing Corporate Portfolio Management: Aligning Investment Proposals with Organizational Strategy. New York, NY: Wiley.
Hubbard, D. (2007). How to Measure Anything: Finding the Value of Intangibles in Business. New York, NY: John Wiley & Sons.
Shan, R., McGuin, P., & Waller, J. (2007). Project Portfolio Management: Leading the Corporate Vision. Basingstoke: Palgrave Macmillan.
Stan, R. (2009). Louisiana Joins Build America Bond Parade with $121 Million. Wall Street Journal, 3(1).
Wesalo, T. (2001). The Fundamentals of Municipal Bonds: The Bond Market Association. New York, NY: John Wiley and Sons.