Abstract
Using the information in credit default swaps, we directly estimate the default, tax and liquidity components in the corporate yield spread from a generalized pricing model with taxes. Incorporating the credit default swap information facilitates disentangling the liquidity and default premia while including the tax rate in the pricing model helps identify the magnitude of tax premium. The model permits a more precise estimate of the liquidity premium by separating it from the tax component in the nondefault spread. We find that a substantial portion of the nondefault component in the corporate yield spread is due to taxes. The estimated liquidity component of the spread is highly correlated with bond-specific and marketwide liquidity proxies whereas the tax component is insensitive to these liquidity measures. Results indicate that the generalized model with taxes does a better job than the existing models in identifying the components of corporate yield spreads.
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