Taxes, Default Risk, and Yield Spreads

Recent events have highlighted the potential importance of nonlinear efiects of flscal variables (notably debt and deflcits) on interest rates: While in times when government solvency is not a concern the standard crowding-out efiects are of moderate magnitude, in times when default risk becomes an issue the interest rate efiects can become very large. This paper provides new evidence on the magnitude of these efiects. For the case when default risk is not a concern, it uses an arbitrage-free term structure model to estimate the dynamic efiects of flscal policy shocks on interest rates along the entire maturity spectrum. For the case when default risk becomes a concern (thereby violating a central assumption of the term structure model), I present evidence based on EMU government bond spread regressions on time-varying efiects of national flscal policies on spreads as well as the time-varying sensitivity of yield spreads to international risk aversion as a function of the state of flscal policy. JEL classiflcation: E6, H6.

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 investor9s 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.

1. Introduction Capital structure decisions are instrumental in everyday managerial finance (Stretcher and Johnson 2011). The principal theoretical narratives on the capital structure choice have focused on the importance of the taxes that burden the supplier of capital on personal or a corporate level (Miller and Modigliani 1961; Modigliani and Miller 1963; Miller 1977). However, the supplier of capital is not the only entity whose income is taxed. For every dollar of corporate sales, there may be a consumption on the consumer. Since this is not a on the investor, but a on the consumer, the consumption is considered to be an irrelevant topic in the capital structure debate, but only seemingly so: the consumption affects the quantity and the price of the goods that are sold and it thus affects corporate cash flows, capital budgeting and investment financing. This is the tax effect. Unless supply is perfectly elastic or demand is perfectly inelastic, the consumption ends up burdening not only the consumer but also the producer. Having been through the literature, there has not been any previous theoretical or empirical research to explore the effect of incidence and the consumption on leverage, yield spreads and agency conflicts between shareholders and creditors. In this direction, the following analysis demonstrates the negative effect of the incidence (on the producer) and the consumption on the investment and default thresholds, delaying entry and precipitating default. The incidence effect and the consumption are also shown to have a negative effect on yield spreads, agency cost of debt and the optimal leverage ratio. The impact of consumption and incidence on investment timing and financing naturally affects corporate revenues and therefore government revenue from consumption and income taxes. In this model, government revenue is studied in a real options framework and optimal policies are estimated, calculating the level of the consumption that maximizes expected government revenue from taxation. The numerical results of this analysis provide us with a new approach to the Ramsey rule on consumption taxes, associating policies with optimal rules of irreversible investment under uncertainty. We proceed with a brief literature review on the association between corporate debt and taxes. Section 3 sets up a theoretical model for our capital budgeting problem of irreversible investment. Section 4 presents numerical results on the effects of the consumption on investment timing, agency costs of debt, yield spreads and optimal leverage. Section 5 calculates expected government revenues from taxes and suggests revenue maximizing policies, based on the effect of the consumption on investment timing and financing. The final section concludes the paper. 2. An Outline of the Debt-and-Narrative Trading shields of corporate debt for bankruptcy costs: this is the main platform of the real options approach to the interaction between operating and financing decisions. Of course, this modeling idea is not fundamentally a real-options one. Laying the foundations of modern microeconomic thought on corporate finance, Miller and Modigliani (1961) and Modigliani and Miller (1963) showed that a firm could actually increase its value without affecting its operating income, implementing an appropriate choice of the capital structure mix. The optimal magnitude of debt financing depends on the effects of the shields of corporate debt and the costs of financial distress. In this framework, it is the rate on corporate income that drives the capital structure choice. This theoretical result has generated significant implications for the theory and practice of corporate finance and there has been empirical evidence to show a positive effect of corporate income on the extent of debt financing (e. …

The intersection of market and credit risk

This paper contributes to the burgeoning literature on the so-called “risk-taking channel” of monetary policy by constructing a partial equilibrium model of the commercial loan market, where conventional monetary policy influences bank lending standards and, by extension, the risk of bank default. In the model, borrower heterogeneity in terms of entrepreneurial abilities and project revenue results in optimal commercial bank lending standards. These standards take the form of a minimum ability requirement: only borrowers with abilities greater than or equal to the minimum threshold receive a loan; the rest are completely excluded from the loan market. After loans are made, a negative aggregate shock that lowers all borrowers’ project revenue results in unexpected loan losses for the bank that may push it into default. In the baseline model, lending standards loosen and the probability of bank default rises when the central bank’s policy rate falls, a result that suggests that asset quality and lending standards may play an important role in shaping the risk-taking channel of monetary policy. However, the relationship between bank default and the policy rate is sensitive to the extent of bank capitalization. While default risk and the policy rate are negatively correlated at relatively strongly capitalized banks, the risk of default at more weakly capitalized banks increases with the policy rate. Additionally, default risk at strongly capitalized banks is more responsive to changes in the policy rate than at weakly capitalized banks. This paper contributes to the literature on the risk-taking channel of monetary policy. First, the model enables analysis of the impact of monetary policy on risk-taking in a setting where both bank asset quality and leverage play a role in shaping the risk of bank default. Second, the model’s results on the role of bank capitalization imply that the tradeoff between financial stability and monetary policy depends crucially on bank capital ratios. This suggests that recent changes to bank capital requirements embodied in new post-2008 financial crisis regulations may impact the nature and size of the risk-taking channel.

Introduction Three main variables affect the credit risk of a financial asset: (i) the probability of default (PD), (ii) the ‘loss given default’ (LGD), which is equal to one minus the recovery rate in the event of default (RR), and (iii) the exposure at default (EAD). While significant attention has been devoted by the credit risk literature on the estimation of the first component (PD), much less attention has been dedicated to the estimation of RR and to the relationship between PD and RR. This is mainly the consequence of two related factors. First, credit pricing models and risk management applications tend to focus on the systematic risk components of credit risk, as these are the only ones that attract risk-premia. Second, credit risk models traditionally assumed RR to be dependent on individual features (e.g. collateral or seniority) that do not respond to systematic factors, and therefore to be independent of PD. This traditional focus only on default analysis has been partly reversed by the recent increase in the number of studies dedicated to the subject of RR estimation and the relationship between the PD and RR (Fridson et al . 2000, Gupton et al . 2000, Altman et al . 2001, Altman et al . 2003, 2005, Frye 2000a, 2000b, 2000c, Hu and Perraudin 2002, Hamilton et al . 2001, Jarrow 2001 and Jokivuolle and Peura 2003). This is partly the consequence of the parallel increase in default rates and decrease of recovery rates registered during the 1999–2002 period.

Using samples of corporate bonds issued by Chinese A-share firms from 2014 to 2021, we examine whether information about bond defaults transmits to other bonds underwritten by a common underwriter. We document that during the underwriting process for a new corporate bond, if any prior bonds underwritten by the same underwriter have defaulted, the yield spread of the new corporate bond increases significantly. Specifically, such a new bond, on average, has a yield spread that is 16.8 basis points higher than one without a common underwriter. The results suggest that investors perceive the default risk of a new bond increases due to a deteriorated reputation of the underwriter. Additional analyses suggest that the adverse effect of the new bond yield spread is less salient when an underwriter has a strong reputation, is state-owned, or has foreign shareholding; the issuer is state-owned or dual listed overseas. Overall, default information in the bond market transmits through common underwriters.

66 ON THE PRICING OP BOND DEFAULT RISK T he pricing of default risk is a crucial part of fixed-income analysis. Investors wishing to allocate assets across different classes need to be comfortable that the yield spread on corporate bonds over similarmaturity default-free government bonds is sUfficient for the added risk borne. There is no consensus as to the exact cost of a unit of additional risk; the analYSt must juggle a variety offactors to determine a·fairprice. In this.article we give a new interpretation ofthe capital assetpricing model valuation ofbonds subject to default risk. Following Jonkhart [1979] and others, we assume that, between coupon payments, an issuer can default (go bankrupt) with a constant probability p. This leads to a valuation for the bond expressed in terms of p. We then express the bond's ~ in terms of p, and develop some interesting survival probabilities and a capital risk measure based on these probabilities. ',' .

This study aims to examine the impact of the net‐zero policy on forward default risk at the firm level within the energy sector of the US, spanning over the period 2007–2021. The research employs Panel Vector Autoregression (PVAR) modeling, as well as linear and non‐linear Autoregressive Distributed Lag (ARDL) models to investigate this relationship. The findings suggest that the implementation of net‐zero policy measures can have complex effects on firms' default risk in both the short and long run. The PVAR results confirm a unidirectional negative impact of net‐zero policies on forward default risk over 2, 3, and 5 years. The symmetric ARDL model results show a negative long‐run impact on the future probability of default, with short‐run impacts being positive across all time horizons. The asymmetric ARDL model findings indicate that positive net‐zero measures reduce the probability of default in the long run and increase it in the short run across all time horizons. Conversely, negative shocks of net‐zero measures lead to an increase in the forward probability of default in the long run. The differences in findings between the long and short run are attributed to the effects of capital expenditures on infrastructure expenses required to achieve net‐zero results. This study contributes to the literature on financial outcomes and the impact of adopting sustainable development and net‐zero goals. The policy implications suggest that a supportive institutional framework must be provided to reduce the financial default in energy sector firms, which will assist in capital and infrastructure expenditures in the short run.

An axiomatic approach to default risk and model uncertainty in rating systems

Default is an increasingly important issue for the Fall, as market stress builds in a weak economic and financial environment rally. The study seeks to investigate if financial tools such as hedging and working capital management can be used for a precaution against default risk in the textile sector of Pakistan. Furthermore, it provides us an analysis on how macroeconomic variables are managed reduces the risk of default. Several elements can potentially impact the likelihood of a corporation experiencing a default on its debt. Nevertheless, this research has only analyzed Working Capital Management, Hedging, and macroeconomic covariables. Data of 102 textile firms was collected for the time of 2015-2020. The objective of this analysis is to assess the influence of these variables on the likelihood of default. The present study employs a logical approach to inquiry. The deductive approach would be the most suitable to evaluate the hypothesis of causation in the study. Our study provides evidence of a strong and statistically significant negative relationship between working capital management and default risk. The importance of the impact of CPI and R&D Investment is observed at a significant level. The statistical significance of the relationship between GDP growth and the probability of default is acceptable. The statistical significance of the impact of interest rates on default likelihood is insignificant. This study offers significant theoretical contributions by incorporating well-established financial theories, including Credit Rationing Theory, to develop a complete framework for understanding default risk. This article examines how these ideas shed light on the behavior of lenders, conflicts of interest inside agencies, and the impact of free cash flow on corporate decision-making. Furthermore, this study investigates the often-overlooked aspect of working capital management and the role of hedging in risk management. This study offers practical insights for finance experts, corporate administrators, legislators, and investors.

The Aggregate Consequences of Default Risk: Evidence from Firm-Level Data

We suggest a methodology to decompose sovereign bond yields into four components (risk‐free, default risk, risk premium, and non‐default) using both sovereign credit default swaps and bond data. Applying the methodology to one of the largest emerging markets, Korea, we find that each fraction varies over time and across bonds. In addition, the default risk accounts for only a small fraction of sovereign yield spreads, and a substantial portion is attributable to risk premium and non‐default components. In particular, the risk premium is substantially time‐varying; moreover, it increases in order to account for a major portion of the heightened yield spread during a financial crisis, implying that global investors prefer to hold safer assets. Therefore, higher risk premiums per unit risk are required than before. Our findings provide evidence on both flight‐to‐quality and time‐varying risk premium.

AN ISSUE OF CONSIDERABLE CONTROVERSY in recent years is whether segmentation exists in the municipal bond market. The presence of market segmentation suggests that securities can be subdivided into distinct groups according to some characteristic and there exists a lack of substitution between these groups on the part of borrowers and/or investors [ 1, 4, 8] . Hendershott and Kidwell [4], for example, found evidence that market segmentation affected yields between regionally and nationally marketed municipal bond issues. Others contend that the municipal bond market is relatively efficient and no permanent segmentation effects can exist [2, 9]. Most recently, Campbell [2] examined possible segmentation resulting from the large acquisitions of municipal securities by commercial banks and found that bank demand for municipal securities had no significant influence on the yield spreads between municipal bonds which differed in default risk, term to maturity, and tax treatment. This is consistent with the argument that the combination of progressive personal income tax rates and fixed corporate income tax rates induces corporations to issue an amount of debt such that the marginal investor in taxable and tax-exempt securities pays taxes at the full corporate rate [9]. If segmentation does not exist, two peculiar features of the term structure of municipal yields cannot be fully explained. For one, municipal yields have almost always increased monotonically with maturity. This is true both for market averages of similarly rated municipal securities and for reoffering yields on individual serial

Prior research uses the basic one-period European call-option pricing model to compute default measures for individual firms and concludes that both the size and book-to-market effects are related to default risk. For example, small firms earn higher return than big firms only if they have higher default risk and value stocks earn higher returns than growth stocks if their default risk is high. In this paper we use a more advanced compound option pricing model for the computation of default risk and provide a more exhaustive test of stock returns using univariate and double-sorted portfolios. The results show that long/short hedge portfolios based on Geske measures of default risk produce significantly larger return differentials than Merton’s measure of default risk. The paper provides new evidence that mediates between the rational and behavioral explanations of value premium.