CHAPTER A PP LI CATI O N The Risk and Term Structure of Interest Rates 119 Effects of the Bush Tax Cut on Bond Interest Rates in the United States The Bush tax cut passed in 2001 scheduled a reduction of the top income tax bracket from 39% to 35% over a ten-year period What is the effect of this income tax decrease on interest rates in the municipal bond market relative to those in the U.S Treasury bond market? A supply and demand analysis similar to that in Figure 6-2 provides the answer A decreased income tax rate for wealthy people means that the after-tax expected return on tax-free municipal bonds relative to that on U.S Treasury bonds is lower because the interest on Treasury bonds is now taxed at a lower rate Because municipal bonds now become less desirable, their demand decreases, shifting the demand curve to the left, which lowers their price and raises their interest rate Conversely, the lower income tax rate makes U.S Treasury bonds more desirable; this change shifts their demand curve to the right, raises their price, and lowers their interest rates Our analysis thus shows that the Bush tax cut has caused interest rates on municipal bonds to rise relative to interest rates on Treasury bonds With the possible repeal of the Bush tax cuts that may occur with the Obama administration, this analysis would be reversed Higher tax rates would raise the after-tax expected return on tax-free municipal bonds relative to Treasuries Demand for municipal bonds would increase, shifting the demand curve to the right, which would raise their price and lower their interest rate Conversely, the higher tax rate would make Treasury bonds less desirable, shifting their demand curve to the left, lowering their price, and raising their interest rate Higher tax rates would thus result in lower interest rates on municipal bonds relative to the interest rate on Treasury bonds Summary In general, the risk structure of interest rates (the relationship among interest rates on bonds with the same maturity) is explained by three factors: default risk, liquidity, and the income tax treatment of the bond s interest payments As a bond s default risk increases, the risk premium on that bond (the spread between its interest rate and the interest rate on a default-free Canadian government bond) rises The greater liquidity of Canada bonds also explains why their interest rates are lower than interest rates on less liquid bonds If a bond has a favourable tax treatment, as municipal bonds in the United States whose interest payments are exempt from federal income taxes, its interest rate will be lower TE RM ST RU CTU RE O F I N TE REST RAT ES We have seen how risk, liquidity, and tax considerations (collectively embedded in the risk structure) can influence interest rates Another factor that influences the interest rate on a bond is its term to maturity: bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is different A plot of the yields on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations is called a yield curve, and it describes the term structure of interest rates for particular types of bonds, such as government bonds The Financial News box Yield Curves shows several