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CFA Level I · CFA Level I Exam · Fixed-Income Cash Flows and Types

An investor in a country that taxes bond coupons at ordinary rates and taxes capital gains at a lower rate is comparing two bonds of equal credit quality and maturity. Bond X trades at a deep discount to par with a low coupon, and Bond Y trades near par with a high coupon. Holding pre-tax yield equal, the bond most likely offering the higher after-tax yield, and the reason, is:

Bond X most likely offers the higher after-tax yield, because more of its return comes from the discount accreting to par, which is taxed at the lower capital gains rate. Bond Y's return is mostly coupon income taxed at the higher ordinary rate.

  1. ABond Y, because coupon income is taxed at a lower rate
  2. BBond X, because more of its return is taxed as a capital gainCorrect
  3. CBoth bonds equally, because pre-tax yields are equal

Explanation

Bond X's return comes mostly from price accretion to par, taxed at the lower capital gains rate, while Bond Y's return is mostly coupon taxed at the higher ordinary rate. With equal pre-tax yields, Bond X has the higher after-tax yield.

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