Taxes, Default Risk, and Yield Spreads

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 yield...

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Bibliographic Details
Published in:The Journal of finance (New York) 1985-09, Vol.40 (4), p.1127-1140
Main Authors: YAWITZ, JESS B., MALONEY, KEVIN J., EDERINGTON, LOUIS H.
Format: Article
Language:English
Subjects:
Bonds
Credit risk
Default
Economic models
Estimated taxes
Impacts
Income taxes
Investors
Municipal bonds
Municipal taxes
Prices
Risk
Statistical analysis
Tax payments
Tax rates
Taxable bonds
Taxes
Yield
Yield curves
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Summary: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.
ISSN:0022-1082
1540-6261
DOI:10.1111/j.1540-6261.1985.tb02367.x