Effects of Credit Quality on Tax-Exempt and Taxable Yield

Publication Type

Journal Article

Publication Date

2003

Abstract

An examination of the effects of credit quality on the relative yields of Treasuries and municipals reveals that the municipal term structure model with no default risk underestimates equilibrium marginal income tax rates and yields of municipals relative to yields of Treasuries. The downward bias is more severe for long-maturity and low-rated bonds. Incorporating default risk into the municipal term structure model helps explain a considerable portion of the relative yields of tax-exempt and taxable bonds, and generates much more accurate estimates of implicit marginal income tax rates. After controlling for the effect of default, the estimated implicit tax rates for long and short bonds become quite comparable and consistent with the tax regime.

Discipline

Business

Research Areas

Finance

Publication

Journal of Fixed Income

Volume

2

Issue

2

First Page

80

Last Page

99

ISSN

1059-8596

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