Term structure effects on default risk premia and the relationship of default-risky tax-exempt yields to risk-free taxable yields — a note

Abstract

The behavior of the default risk premium on bonds has caught the attention of many researchers. Some researchers have analyzed how default risk premia may vary with maturity. It has been suggested that default risk premia are independent of maturity; however, recent research by Rodriguez (1988) shows this to not hold for nonpar taxable bonds. This research shows that the shape of the underlying term structure affects default risk premia for even par bonds in a systematic way. Furthermore, the maturity-dependent variation in equilibrium tax rates has a strong impact upon default risk premia behavior where equilibrium tax rates are derived from comparisons of taxable and tax-exempt bonds. The inclusion of the shape of the underlying term structure also has very important implications for the relation between taxexempt yields and taxable yields. The slope and intercept terms of the relation between taxexempt and taxable yields are clearly dependent upon maturity, a fact which has not been recognized before.