Taxes, Default Risk, and Credit Spreads

Abstract

Most term structure models of defaultable bonds have ignored personal tax effects. This research examines the effects of omitting taxes on empirical estimation of yield spreads and default probability. The model accounts for the effects of taxes on investor's trading strategy. It is found that ignoring the interactive effects of taxes and default results in a substantial underestimation of yield spreads between corporate and Treasury bonds. The problem of spread underestimation is more severe in percentage terms for high-grade bonds than for low-grade bonds. Failure to account for tax effects results in an upward-biased estimate of default probability, a bias positively related to maturity and tax rates and negatively related to bond quality.