In the regular tax environment, which type of bonds is preferable?

• A. Taxable bonds
• B. Tax-exempt bonds
• C. Municipal bonds
• D. Corporate bonds

Answer: (B)

Understanding after-tax return is essential here. In a regular tax environment, the benefit goes to bonds whose interest isn’t taxed by the federal government. Interest from tax-exempt bonds is not subject to federal income tax, so the investor’s after-tax yield equals the stated coupon rate. That makes them more attractive than taxable bonds when you’re comparing after-tax returns, especially for someone in a moderate or high tax bracket.

For example, if a taxable bond yields 6% and the investor faces a 35% federal tax, the after-tax yield is 6% × (1 − 0.35) = 3.9%. A tax-exempt bond yielding 4% would give an after-tax return of 4%, which is higher. The tax-exempt status is the key advantage in the regular tax regime.

Municipal bonds are a common type of tax-exempt bond, but the important point is the tax-exempt nature of the interest, which is why tax-exempt bonds are preferable in this context.