Question

Over the years we have seen large changes in US federal income tax rates, with the highest marginal rates falling from 70% to under 40% today. Describe the impact of this change on the spread between US Treasury bonds and municipal bonds.

Answer 1

Us federal income tax rate has an inverse relation with bonds. As the interest rates rise there is fall in the bond prices. When the income tax rate rises the investor moved more towards the investment instrument where they can save income tax. Now coming towards the above scenario, will have it explained below.

1. US treasury bonds

Us treasury bonds are issued by the government hence the interest earned from treasury bond is often taxable at the federal level and not at local or state level. This bonds come with fixed maturity and are risk free bonds. Hence if the income tax rate falls at lower rate then the price of the bonds increase as more investors moved towards treasury bonds. In the above scenario the income tax rate went from 70% to less than 40% this would directly affect the Us treasury bonds price.

2. Municipal Bonds

Unlike the US treasury bonds the Municipal bonds are tax free from the federal , state and local levels. However they carries little risk as the state can impose tax to cover debt hence there is little default risk as compared to the treasury bonds. Hence increase in the income tax rate shouldn't affect the municipal bonds as much as it affect for treasury bonds as Municipal bonds are tax free.

Impact of income tax rate change on the spread between US treasury bonds and Municipal bonds.

Considering if both bonds pay same interest rate then the actual yield of municipal will be more than that of treasury bond if the interest rate rise as unlike Municipal bonds treasury bonds are taxable at federal level. Hence as the yield for municipal bonds increase then spread will increase simultaneously Vice- versa if the income tax rate falls then the yield for treasury bonds will increase and spread between US treasury bond and municipal bonds will decrease.

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