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118 PA R T I I Financial Markets The result is that the spread between the interest rates on the two bond types has risen Therefore, the differences between interest rates on corporate bonds and Canada bonds (that is, the risk premiums) reflect not only the corporate bond s default risk but its liquidity too This is why a risk premium is more accurately a risk and liquidity premium, but convention dictates that it be called a risk premium In Canada, coupon payments on fixed-income securities are taxed as ordinary Income Tax Considerations income in the year they are received In some other countries, however, certain government bonds are not taxable In the United States, for example, interest payments on municipal bonds are exempt from federal income taxes, and these bonds have had lower interest rates than U.S Treasury bonds for at least 40 years How does taxation affect the interest rate on bonds? Let us imagine that you have a high enough income to put you in the 40% income tax bracket, where for every extra dollar of income you have to pay 40 cents to the government If you own a $1000-face-value taxable bond that sells for $1000 and has a coupon payment of $100, you get to keep only $60 of the payment after taxes Although the bond has a 10% interest rate, you actually earn only 6% after taxes Suppose, however, that you put your savings into a $1000-face-value taxexempt bond that sells for $1000 and pays only $80 in coupon payments Its interest rate is only 8%, but because it is a tax-exempt security, you pay no taxes on the $80 coupon payment, so you earn 8% after taxes Clearly, you earn more on the tax-exempt bond, so you are willing to hold the bond even though it has a lower interest rate than the taxable bond Notice that the tax-exempt status of a bond becomes a significant advantage when income tax rates are very high APP LI CAT IO N Tax-Exempt versus Taxable Bonds Suppose you had the opportunity to buy either a tax-exempt bond or a taxable bond, both of which have a face value and purchase price of $1000 Assume both bonds have identical risk The tax-exempt bond has coupon payments of $60 and a coupon rate of 6% The taxable bond has coupon payments of $80 and an interest rate of 8% Which bond would you choose to purchase, assuming a 40% tax rate? Solution You would choose to purchase the tax-exempt bond because it will earn you $60 in coupon payments and an interest rate after taxes of 6% In this case, you pay no taxes on the $60 coupon payments and earn 6% after taxes However, you have to pay taxes on taxable bonds You will keep only 60% of the $80 coupon payment because the other 40% goes to taxes Therefore, you receive $48 of the coupon payment and have an interest rate of 4.8% after taxes Buying the tax-exempt bond would yield you higher earnings
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