The Effect of Risk-Aversion on the Portfolio Allocation between Taxable Bonds and Non-Taxable Bonds of the Same Risk

A well-known proposition found in numerous textbooks, as well as in marketing materials distributed by bond salesmen, asserts that a lower-yielding municipal bond can provide the same after-tax return as a higher-yielding corporate bond, ceteris paribus. A simple algebraic “equivalence relation†is sometimes adduced to illustrate what the before-tax yield on the corporate must be if its after-tax yield to the investor is to be equal to the yield on a municipal. A portfolio policy implication frequently suggested is that if the after-tax yield on the corporate is equal to the yield on the municipal, ceteris paribus , the “rational†investor should be indifferent to his allocation between the two. This paper constructs a theory to demonstrate the dubious validity of that investment policy. The theory in this paper relies on the assumptions respecting the risk-aversive attitude of investors as well as the presence of risky taxable income statistically independent of the income from the bonds. The main results of the analysis are expressed by two propositions that establish that the risk-averse investor will choose a specific allocation of his bond portfolio and will require a risk premium to induce him to hold municipals of the same risk as corporates.