CFA Practice Question

CFA Practice Question

Jane Collins, a portfolio manager with a large buy-side investment bank, is considering investing in two bond issues. One issue is a tax-free municipal, and the other is a corporate bond. In her analysis, Ms. Collins has gathered the following information:

Yield on municipal bond: 3.43% per year
Yield on corporate bond: 8.33% per year

Assuming that both bonds are identical in term, that neither possess any embedded options, and that all income will be taxed at a 30% marginal tax rate, what is the absolute yield spread between these two securities? (Use the taxable-equivalent yield in your calculation) Further, is this measurement best described as an intermarket sector spread or an intramarket sector spread?
A. 387 basis points, intermarket sector spread
B. 343 basis points, intermarket sector spread
C. 387 basis points, intramarket sector spread
Explanation: The yield spread between two debt securities from two different sectors of the bond market is referred to as an "intermarket sector spread." In this example, one of the bonds is a municipal issue, and the other is a corporate issue. These are totally different sectors of the bond market.

Since the income produced by municipal bonds is generally not taxable, it is necessary to compute the tax-equivalent yield before the municipal bond can be compared to a taxable issue. To calculate the tax-equivalent yield, use the following formula:
{Tax equivalent yield = [yield on non-taxable issue / (1 - tax rate)]}

Imputing the given information into this equation will show a taxable equivalent yield of 4.9% for this municipal issue. The calculation of the relative yield spread between the taxable equivalent yield on this municipal issue and the comparable corporate issue is shown below:
{Absolute yield spread = [0.0833 - 0.049] = 0.0343}, or 343 basis points.

The fact that the absolute yield spread between these two debt securities is equal to the yield on the municipal issue is only a coincidence.

While typically both an intermarket sector spread and a intramarket sector spread are measured by the absolute yield spread between two securities, this is not requisite. So said, a relative yield spread, or a yield ratio can also be classified as either an intermarket sector spread or an intramarket sector spread.

User Contributed Comments 4

User Comment
smillis Could I take (1-Tax Rate) of corporate bond to make it equivalent to the yield of the municiple bond?

8.33 * (1-30%) = 5.83% vs 3.43% Municiple or 240 bp?
alki the q specifically says "(Use the taxable-equivalent yield in your calculation"
thekapila otherwise..if you calculate with corporate bond..its 240 bp..which is incorrect in line with answers..and also when u calculate yield spread you always choose base to be equivalent to the compare..
so here you will make muni comparable to crporate.
grezavi good point alki, thanks !
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