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1. What would happen to the spreads between different types of bonds if the federal government made
Treasuries tax-exempt and at the same time raised income taxes considerably?
2. If the Supreme Court unexpectedly declared a major source of municipal government tax revenue illegal, what would happen to municipal bond yields?
3. If several important bond brokers reduced the brokerage fee they charge for trading Baa corporate bonds
(while keeping their fees for other bonds the same), what would happen to bond spreads?
4. What happened to bond spreads when Enron, a major corporation, collapsed in December 2001?
Answer : 1.The U.S. government has never defaulted on its bonds and is extremely unlikely to do so because even if its much-vaunted political stability were to be shattered and its efficient tax administration (that wonderful institution, the Internal Revenue Service [IRS]) were to stumble, it could always meet its nominal obligations by creating money. (That might create inflation, as it has at times in the past. Nevertheless, except for a special type of bond called TIPS, the government and other bond issuers promise to pay a nominal value, not a real [inflation-adjusted] sum, so the government does not technically default when it pays its obligations by printing money.) 2.The risk structure of interest rates explains why bonds of the same maturity but issued by different economic entities have different yields (interest rates).The three major risks are default, liquidity, and after-tax return.By concentrating on the three major risks, you can ascertain why some bonds are more (less) valuable than others, holding their term (repayment date) constant.if not outright predict, the changes in rank order as well as the spread (or difference in yield) between different types of bonds.A flight to quality occurs during a crisis when investors sell risky assets (like below-investment-grade bonds) and buy safe ones (like Treasury bonds or gold). 3.Corporate Baa bonds have the highest yields because they have the highest default risk (of those graphed), and the markets for their bonds…

are generally not very liquid. Corporate Aaa bonds are next because they are relatively safer (less default risk) than Baa bonds and they may be relatively liquid, too. U.S. Treasuries are extremely safe and the markets for them are extremely liquid, so their yields are lower than those of corporate bonds. In other words, investors do not need as high a yield to own Treasuries as they need to own corporates. Another way to put this is that investors place a positiverisk premium(to be more precise, a credit or default risk, liquidity, and tax premium) on corporate bonds. 4. The low yield on munis is best explained by their tax exemptions. Before income taxes became important, the yield on munis was higher than that of Treasuries, as we would expect given that Treasuries are more liquid and less likely to default. During World War II, investors, especially wealthy individuals, eager for tax-exempt income and convinced that the fiscal problems faced by many municipalities during the depression were over, purchased large quantities of municipal bonds, driving their prices up (and their yields down).Almost all the time since, tax considerations, which are considerable given our highest income brackets exceed 30 percent, have overcome the relatively high default risk and illiquidity of municipal bonds, rendering them more valuable than Treasuries, ceteris paribus. 4.


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