At what tax rate are investors indifferent between corporate and municipal bonds, given their yields?

Investors evaluate the returns on corporate and municipal bonds based on their after-tax yields, as municipal bonds often provide tax-exempt interest while corporate bonds are subject to taxation. To determine the tax rate at which investors are indifferent between the two, we consider the yield on a corporate bond and the yield on a tax-exempt municipal bond.

The formula to find the tax-equivalent yield of a municipal bond is:

Tax-equivalent yield = Municipal bond yield / (1 - tax rate)

To find the tax rate where the after-tax yield of the corporate bond matches the yield of the municipal bond, you set the tax-equivalent yield equal to the yield on the corporate bond. This means solving for the tax rate when the after-tax income from the corporate bond equals the income from the municipal bond.

The correct answer indicates that at a tax rate of 33.73%, both investments yield the same after-tax return. This implicates that when an investor is in the 33.73% tax bracket, they would receive equal satisfaction from both types of bonds, making them indifferent to their choice based solely on yield.

This level of tax rate represents a balance point for the investor, where they are effectively neutral to the taxation of the corporate