The Effects of Personal Taxes and Default Risk on Bond Duration

Yan Alice Xie, Dan Han () and Howard Qi ()
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Yan Alice Xie: Department of Accounting and Finance, University of Michigan-Dearborn, 19000 Hubbard Drive, Dearborn, MI 48126, USA
Dan Han: Department of Mathematics, University of Louisville, Louisville, KY 40292, USA
Howard Qi: Department of Accounting, Economics, and Finance, Northern Arizona University, Flagstaff, AZ 86011, USA

Review of Pacific Basin Financial Markets and Policies (RPBFMP), 2023, vol. 26, issue 04, 1-39

Abstract: Using the structural approach to derive tax-adjusted duration for defaultable bonds under stochastic interest rate process, we thoroughly investigate the effects of personal taxes, default risk, and their interaction on bond duration. The simulation results show that default risk reduces duration, while personal taxes increase duration. Premium amortization and discount accretion further enhance the positive impact of personal taxes on duration. The interactive effect of default risk and personal taxes on duration depends on which effect dominates. Also, the tax effect on duration changes with bond features, bond issuers’ debt policy, and interest rate level. Our empirical results validate the positive tax effect on duration by showing that duration of corporate bonds is significantly longer than that of municipal counterparts with the same credit rating, coupon rate, and maturity. Our study provides timely information on how to accurately measure interest rate risk under the current circumstance that interest rate is increasing substantially from the low level and personal taxes are expected to increase.

Keywords: Bond duration; tax effect; default risk; amortization; capital structure policy (search for similar items in EconPapers)
JEL-codes: G12 G21 (search for similar items in EconPapers)
Date: 2023
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DOI: 10.1142/S0219091524500012

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