{"id":5594,"date":"2009-02-21T01:36:22","date_gmt":"2009-02-21T05:36:22","guid":{"rendered":"http:\/\/www.prefblog.com\/?p=5594"},"modified":"2009-02-21T01:36:22","modified_gmt":"2009-02-21T05:36:22","slug":"us-corporate-bond-spreads-taxation-effects","status":"publish","type":"post","link":"https:\/\/prefblog.com\/?p=5594","title":{"rendered":"US Corporate Bond Spreads: Taxation Effects"},"content":{"rendered":"

An interesting paper by Edwin J. Elton, Martin J. Gruber, Deepak Agrawal & Christoper Mann, Explaining the Rate Spread on Corporate Bonds<\/a>. The authors’ thesis is:<\/p>\n

Spreads in rates between corporate and government bonds differ across rating classes and should be positive for each rating class for the following reasons:
\n1. Expected default loss\u2014some corporate bonds will default and investors require a higher promised payment to compensate for the expected loss from defaults.
\n2. Tax premium\u2014interest payments on corporate bonds are taxed at the state level whereas interest payments on government bonds are not.
\n3. Risk premium\u2014The return on corporate bonds is riskier than the return on government bonds, and investors should require a premium for the higher risk. As we will show, this occurs because a large part of the risk on corporate bonds is systematic rather than diversifiable.<\/p><\/blockquote>\n

… and they conclude …<\/p>\n

Several findings are of particular interest. The ratings of corporate bonds, whether provided by Moody\u2019s or Standard and Poor\u2019s, provide material information about spot rates. However, only a small part of the spread between corporate and treasuries and the difference in spreads on bonds with different ratings is explained by the expected default loss. For example, for 10-year A-rated industrials, expected loss from default accounts for only 17.8
\npercent of the spread.<\/p>\n

Differential taxes are a more important influence on spreads. Taxes account for a significantly larger portion of the differential between corporate and treasuries than do expected losses. For example, for 10-year A-rated bonds, taxes accounted for 36.1 percent of the difference compared to the 17.8 percent accounted for by expected loss. State and local taxes are important because they are paid on the entire coupon of corporate bonds, not just on the difference in coupon between corporate and treasuries. Despite the importance of the state and local taxes in explaining return differentials, their impact has been ignored in almost all prior studies of corporate rates.<\/p>\n

Even after we account for the impact of default and taxes, there still remains a large part of the differential between corporate and treasuries that remains unexplained. In the case of 10-year corporates, 46.17 percent of the difference is unexplained by taxes or expected default. We have shown that the vast majority of this difference is compensation for systematic risk and is affected by the same influences that affect systematic risks in the stock market. Making use of the Fama\u2013French factors, we show that as much as 85 percent of that part of the spread that is not accounted for by taxes and expected default can be explained as a reward for bearing systematic risk.<\/p><\/blockquote>\n

The assumption embedded in their argument is that the marginal US corporate bond buyer is taxable.<\/p>\n

The authors claim:<\/p>\n

Because the marginal tax rate used to price bonds should be a weighted average of the active traders, we assume that a maximum marginal tax rate would be approximately the midpoint of the range of maximum state taxes, or 7.5 percent. In almost all states, state tax for financial institutions (the main holder of bonds) is paid on income subject to federal tax. Thus, if interest is subject to maximum state rates, it must also be subject to maximum federal tax, and we assume the maximum federal tax rate of 35 percent.<\/p><\/blockquote>\n","protected":false},"excerpt":{"rendered":"

An interesting paper by Edwin J. Elton, Martin J. Gruber, Deepak Agrawal & Christoper Mann, Explaining the Rate Spread on Corporate Bonds. The authors’ thesis is: Spreads in rates between corporate and government bonds differ …<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[12],"tags":[],"class_list":["post-5594","post","type-post","status-publish","format-standard","hentry","category-interesting-external-papers"],"_links":{"self":[{"href":"https:\/\/prefblog.com\/index.php?rest_route=\/wp\/v2\/posts\/5594","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/prefblog.com\/index.php?rest_route=\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/prefblog.com\/index.php?rest_route=\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/prefblog.com\/index.php?rest_route=\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/prefblog.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcomments&post=5594"}],"version-history":[{"count":0,"href":"https:\/\/prefblog.com\/index.php?rest_route=\/wp\/v2\/posts\/5594\/revisions"}],"wp:attachment":[{"href":"https:\/\/prefblog.com\/index.php?rest_route=%2Fwp%2Fv2%2Fmedia&parent=5594"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/prefblog.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcategories&post=5594"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/prefblog.com\/index.php?rest_route=%2Fwp%2Fv2%2Ftags&post=5594"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}