After-Tax Investment Results from Long-Term vs. Short-Term Discount Coupon Bonds

Abstract

The differential taxation of capital gains and ordinary income has important practical implications for the bond investor. With the capital gains tax rate being only 40 per cent of the ordinary rate, it pays to buy bonds whose pretax yields are mostly in the form of capital gains, everything else equal. The lower the coupon, the greater the fraction of total return comprised of capital gains. Surprisingly, it does not always pay to buy long-term discount bonds in order to postpone the payment of capital gains taxes. Given the same pretax yields on long and short-maturity bonds, it is better, at most coupon levels, to roll over shortterm bonds, even though the capital gains tax must be paid earlier. This suggests a reason why pretax yields are higher on long-term bonds: They must compensate for the higher rate of effective taxation. Empirical evidence supports the hypothesis that the term structure is upward sloping at least partly because a smaller fraction of the total return on long-term bonds is in the form of capital gains.