Question

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.

Answer 1

Answer: 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.

Step-by-step explanation:

The Local Government is threatened with bankruptcy. This increases their default risk because the default risk is the risk that the borrower will not be able to pay back. Should the Local Government go bankrupt they will be unable to pay.

Default risk is one of the constituents of the Risk Premium. When the Default Risk rises, the Risk Premium will rise as well which will have the effect of increasing the Yield on the Local Government bonds.

The Tax Exempt status of the bond was another reason why the bond yield was as low as it was. With the elimination of that status, the Yield will rise as well.

The Spread between the Treasury Yields and the Local Government Yields refers to the difference between them. With the Local Government Yield originally below that of the Treasury Yield, the Spread was positive meaning the Treasury Yield was higher.

With these new increases in the Yield, the Local Government Yield will increase past the Treasury Yield which will then push the Spread negative hence there will be a change of signs.

For instance, LG Yield was originally 3% and Treasury Yield was 5%. Spread was 2%. Risk Premium Increase and Tax Exempt status elimination force LG yield up to 6% and now Spread is -1%. Spread has changed signs.