The nominal interest rate on taxable bonds is 8%, while on municipal bonds (which aren't taxable) it is 5%. The expected inflation rate is 3% and the tax rate on interest income is 40%. Calculate the expected real after-tax interest rate on both bonds. Which would be the better investment? Now suppose the actual inflation rate turned out to be 6%. Which bond was the better investment? Would your answer change if inflation had turned out to be 0%?
What will be an ideal response?
ra-t (taxable bond) = (1 - 0.40)8% - 3% = 1.8%; ra-t (municipal bond) = 5% - 3% = 2%; municipal bond is the best buy; note that the same expected inflation rate is subtracted from both, so it doesn't matter what the actual inflation rate turns out to be the municipal bond is always the best.
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