Question

Why are high-tax-bracket investors more inclined to invest in municipal bonds than are low-bracket investors?

Short answer

High-tax-bracket investors invest in municipal bonds because the interest income on these bonds is exempt from federal income taxation.

Step-by-step solution

Definition

Municipal bonds are tax-exempt bonds issued by state and local governments.

Explanation

The high-tax-bracket investors are more inclined to invest in municipal bonds because their interest income is exempt from federal income taxation. It, therefore, offers highly attractive equivalent taxable yields. The higher the bracket, the more valuable the tax-exempt feature of municipal bonds. Thus, high-bracket individuals tend to hold municipal bonds.