The Bush tax cut reduced the top income tax bracket from 39% to 35% over a ten-year period. Supply and demand analysis predicts the impact of this change was a interest rate on municipal bonds and a interest rate on Treasury bonds.

The options for answering this question would be the following:

A) higher; lower

B) lower; lower

C) higher; higher

D) lower; higher

The correct answer is: A) higher; lower.

Explanation:

The price of a bond can be above or below its parity for many reasons, including interest rate adjustments, if the credit rating of the bond has changed, supply and demand, a change in the creditworthiness of the bond issuer , if the bond has been redeemed or if it is likely to be (or not) redeemed, a change in prevailing market interest rates, and an endless number of other factors.

As with other financial assets, bond prices are determined by supply and demand. Each government sets the supply of state bonds, issuing more if necessary. Demand, on the other hand, depends on whether or not it is an interesting investment.

Interest rates can have a major impact on bond demand. If interest rates are lower than the coupon on a bond, the demand for that bond will increase - it represents a better investment. But if interest rates rise above the coupon percentage, demand will drop.  

Some bonds are actively traded, while others may have no activity (there are neither buyers nor sellers  interested) for weeks. As a general category, municipal bonds tend to be more sensitive to supply and demand forces than other fixed income categories. This has the net effect of increasing your market risk: If your bond is not popular with other investors at a time when  you need to sell, the price you will get for the bond in the secondary market will be hit.

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