Peter Wolfgang is looking for ways to lower his taxes. He notices that specific regional bonds issued from the different states in Germany are exempt from both federal and state taxes. A bond issued in the state of Baden-Württemberg carries a coupon of 3%, while a bond issued by Volkswagen AG carries a coupon of 5% and is fully taxable at the federal and land levels. Finally, German government bonds, which are exempt from federal taxes but are taxed at state level, are available at yields of 2%. Peter is in the 45% federal tax bracket, and state (land) taxes are levied at a flat 10%. He has €100,000 to invest and, because all his bond options are highly rated, he wants to select the one that will give him maximum after-tax returns.
a. Which one of the three bonds should he buy?
b. Rank the three bonds (from best to worst) in terms of their taxable equivalent yields.