I printed off a question I got wrong, but I failed to print off the explanation. I can’t seem to find out how to go back to the question (it was a review question not an exam question). It is question JDFKY-8MJ7C. Can someone help explain the answer to me to help me better understand? The question is: “A 7% municipal bond is purchased by a resident in the secondary market at a 8% basis. What best describes the investor’s after tax-yield?” The answer is “between 7%-8%.”
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Hi @Teemoto3! Good question. First, I’ll go ahead and restate the question and answer:
A 7% municipal bond is purchased by a resident in the secondary market at a 8% basis. What best describes the investor’s after-tax yield?
Answer = Between 7% and 8%
First, this is a municipal bond bought by a resident. Therefore, all of the interest received will be tax free. It is a 7% bond, so the 7% is all after-tax return the investor receives.
The 8% basis is the bond’s yield to maturity (YTM). The difference between a bond’s coupon (the 7%) and the bond’s YTM (8%), which is a 1% return, is due to the bond’s market price. In order for an investor’s YTM to be higher than the coupon, the bond must be trading at a discount. That’s where the extra 1% return comes from.
Now, here’s the key point. Although municipal bonds are viewed as tax-free investments, it’s only the coupon (7% return) that’s tax free. If a municipal bond is purchased at a discount in the secondary market*, it is fully taxable. So, the added 1% return the investor receives due to the bond’s discount is taxable, and therefore part of that extra 1% return will go to the IRS. Let’s assume 30% goes to IRS. If that were the case, the investor would only keep 0.7% of the 1% return, resulting in a 7.7% YTM (7% tax-free coupon + 0.7% after tax discount yield).
This topic is a bit complex, so please let me know if you have any additional questions.
*If a municipal bond is bought at a discount as a new issue (in the primary market), the discount is tax-free. Essentially, the discount is only fully taxable if the bond is purchased in the secondary market.
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Thank you! Wow, reading your explanation, this is a tough topic! I think I understand now! I appreciate your time.
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I have a question about the italicized footnote you added, Brandon. If a bond is purchased in the primary market as a new issue, doesn’t that mean that the bond would be issued at par instead of at a discount?
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Hi @Gray - you’re right about your point as a generality. Most bonds are originally issued at par, but this is not always the case, especially with municipal bonds. For example, the Deschutes Country bond I reference in the Series 7 municipal bond issuance chapter. If you click the first link above and scroll to the second page of the PDF, you’ll find all the bonds being issued at premiums (interest rate is higher than the yield).
Bonds can be sold at discounts or premiums at issuance. If a bond is sold at a discount in the primary market, the discount is tax-free. Otherwise, discounts are taxable if purchased in the secondary market.
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Thanks for responding! There’s so much to learn! 
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