Tax on Interest Income on Bonds Assignment | Homework For You

Suppose your local government, threatened with bankruptcy, decided to tax the interest income on its own bonds as part of an effort to rectify serious budgetary woes. If, before the change in tax status, the yields on the bonds described were below the Treasury yield of the same maturity, would you expect this spread to narrow, to disappear, or to change sign after the policy change? Select once answer choice.

A. You would expect the spread to be unaffected by the elimination of the tax-exempt status, as this is not a determinant of bond yields.

B. You would expect the spread to disappear. The lower yields on local government bonds versus Treasuries are due to their tax-exempt status.

C. The loss of tax-exempt status along with the usual risk premium implies that the yields on the local bonds will now be higher than those on Treasuries, so the spread changes sign.

D. You would expect the spread to narrow. The lower yields on local government bonds versus Treasuries are due to their tax-exempt status. Investors would regard local government bonds as safer than Treasuries and so the spread would remain negative.Get Finance homework help today