Sally Is Choosing Between Two Bonds Both of Which Mature

Sally is choosing between two bonds both of which mature in 15 years and have the same level of risk. Bond A is a municipal bond that yields 5.75 percent. Bond B is a corporate bond that yields 7.75 percent. If Sally is in the 28 percent tax bracket, which bond should she select and why?

A) Sally should select Bond A because its interest income is not taxable.
B) Sally will be indifferent between Bond A and B since the taxable equivalent yield of Bond A equals the yield of Bond B.
C) Sally should select Bond A because its TEY is greater than the yield of Bond B.
D) Sally should select Bond B because the TEY of Bond A is less than the yield of Bond B.

Correct Answer:

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