Taxes, Default Risk, and Yield Spreads
Document Type
Article
Keywords
income taxes;municipal bonds;yield curves;estimated taxes;taxable bonds;investors;yield;credit risk;tax payments
Identifier Data
10.1111/j.1540-6261.1985.tb02367.x
Publisher
Wiley, The American Finance Association
Abstract
This paper develops a model of bond prices and yield spreads that incorporates the effect of both taxes and differences in default probabilities. The tax loss consequences of default are recognized. Traditionally, tax-free (municipal) bond yields have been viewed as linearly related to taxable yields with a slope coefficient equal to one minus the tax rate and the intercept representing differences in default risk. While our model supports the linearity assumption, it implies that the slope and intercept are both functions of both the break-even tax rate and the default probability(ies). Clientele effects among both municipal and taxable bonds are demonstrated. Finally, the implied marginal tax rates and the implied default probabilities are estimated for different categories of municipal bonds.
