A corporate bond currently yields 8.5%. Municipal bonds with the same risk, maturity, and liquidity currently yield 5.5%. At what tax rate would investors be indifferent between the two bonds?
Municipal Bonds are attractive in that they give the tax benefit of being tax exempt whereas a corporate bond is liable for taxation. The tax rate that will therefore make an investor indifferent between the two bonds is the one that will equate the Corporate bond's yield net of tax to the yield on the Municipal bond.
