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Chapter 6: Q.11 (page 188)

If the income tax exemption on municipal bonds were abolished, what would happen to the interest rates on these bonds? What effect would the change have on interest rates on U.S. Treasury securities?

Short Answer

Expert verified

Because of a decline in demand for municipal bonds and an increase in demand for Treasury bonds, the interest rate on municipal bonds will rise while the interest rate on Treasury bonds would fall.

Step by step solution

01

Introduction

A bond is a fixed amount of income investment that is given to an entity for a specific length of time.

02

To determine

The impact of eliminating the income tax exemption on bond interest rates, as well as the impact of changing interest rates on US Treasury securities

03

Explanation

Cities, states, and other government organisations issue municipal bonds. Because the tax-exempt benefit would be eliminated, municipal bonds would be less desirable than Treasury bonds.

Because of a decline in demand for municipal bonds and an increase in demand for Treasury bonds, the interest rate on municipal bonds will rise while the interest rate on Treasury bonds would fall.

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Most popular questions from this chapter

Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so?

Do you think that a U.S. Treasury bill will have a risk premium that is higher than, lower than, or the same as that of a similar security (in terms of maturity and liquidity) issued by the government of Colombia?

Which should have the higher risk premium on its interest rates, a corporate bond with a Moody鈥檚 Baa rating or a corporate bond with a C rating? Why?

In 2010 and 2011, the government of Greece risked defaulting on its debt due to a severe budget crisis. Using bond market graphs, compare the effects on the risk premium between U.S. Treasury debt and comparable-maturity Greek debt.

Go to the St. Louis Federal Reserve FRED database, and find daily yield data on the following U.S. treasuries securities: one-month (DGS1MO), three-month (DGS3MO), six-month (DGS6MO), one-year (DGS1), two-year (DGS2), three-year (DGS3), five-year (DGS5), seven-year (DGS7), 10-year (DGS10), 20-year (DGS20), and 30-year (DGS30). Download the last full year of data available into a spreadsheet.

a. Construct a yield curve by creating a line graph for the most recent day of data available, and for the same day (or as close to the same day as possible) one year prior, across all the maturities. How do the yield curves compare? What does the changing slope say about potential changes in economic conditions?

b. Determine the date of the most recent Federal Open Market Committee policy statement. Construct yield curves for both the day before the policy statement was released and the day on which the policy statement was released. Was there any significant change in the yield curve as a result of the policy statement? How might this be explained?
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