econ423lec6

# econ423lec6 - Recall from last time. Rates and spreads on...

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EXPLAINING INTEREST RATE DIFFERENCES JUNE 25 TH , 2009 Lauren Heller Econ 423, Financial Markets The Plan for Today Risk Structure of Interest Rates Income Tax Considerations Term Structure of Interest Rates Explaining the Yield Curve Homework Questions (if time) Rates and spreads on different bond categories change from one year to the next. There are three specific risk factors that might explain this: Default Risk Liquidity Income Tax Considerations Recall from last time… Income Tax Considerations Recall the graph of bond rates from last class:

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Income Tax Considerations Recall the graph of bond rates from last class Municipal bonds tend to have a lower rate than Treasuries, even though: Non-trivial default risk with these types of bonds. Municipal bonds are not as liquid as treasuries. Why? Interest payments on municipal bonds are exempt from federal income taxes Same effect on the demand for municipal bonds as an increase in their expected return. Income Tax Considerations Treasury bonds are exempt from state and local income taxes, while interest payments from corporate bonds are fully taxable. Example Suppose you are in the 30% federal tax bracket and want to invest \$1,000 in either a corporate or municipal bond Assume price = Face value = \$1,000, and that both have a 10% coupon rate. How much would your net coupon payment be from the corporate bond? The municipal bond? Income Tax Considerations Example Suppose you are in the 30% federal tax bracket and want to invest \$1,000 in either a corporate or municipal bond Assume price = Face value = \$1,000, and that both have a 10% coupon rate. How much would your net coupon payment be from the corporate bond? The municipal bond? Corporate bond coupon payment = \$70 Municipal bond coupon payment = \$100 Income Tax Considerations Example Suppose you are in the 30% federal tax bracket and want to invest \$1,000 in either a corporate or municipal bond Assume price = Face value = \$1,000, and that both have a 10% coupon rate. At what municipal coupon rate would you be indifferent between the municipal bond and the corporate bond? Municipal Coupon Rate = 7%