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CFA Level I · CFA Level I Exam · Fixed-Income Instrument Features

In many jurisdictions, interest on bonds issued by municipal or local governments is exempt from income tax. All else equal, the yield on such tax-exempt bonds, relative to comparable taxable bonds, is most likely:

The yield on tax-exempt bonds is most likely lower than on comparable taxable bonds. Investors focus on after-tax returns, so the tax exemption lets issuers offer a lower stated yield while still giving investors an equivalent or better after-tax return.

  1. Ahigher, to compensate for greater credit risk
  2. Blower, because investors accept a lower pre-tax yieldCorrect
  3. Cthe same, because tax status does not affect pricing

Explanation

Investors compare after-tax returns, so tax-exempt bonds can be sold at a lower pre-tax yield than comparable taxable bonds. The tax exemption raises demand and lowers the stated yield. Equal yields would make taxable bonds unattractive to taxpayers.

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