Suppose the yields on tax-exempt local government bonds initially were below the Treasury yields of the same maturity. Suppose then that your local government, threatened with bankruptcy, decided to tax the interest income on its own bonds as part of an effort to rectify serious budgetary woes. If the tax-exempt status were then removed from the local government bonds, would you expect their yield spreads versus Treasuries to narrow, to disappear, or to change sign?

A) You would expect the spread to be unaffected by the elimination of the tax-exempt status, as this is not a determinant of bond yields.

B) You would expect the spread to disappear. The lower yields on local government bonds versus Treasuries are due to their tax-exempt status.

C) You would expect the spread to narrow. The lower yields on local government bonds versus Treasuries are due to their tax-exempt status. Investors would regard local government bonds as safer than Treasuries and so the spread would remain negative.

D) The loss of tax-exempt status along with the usual risk premium implies that the yields on the local bonds will now be higher than those on Treasuries, so the spread changes sign.

Answer rating: 100% (QA)

answer option D Local government bonds are risker than the tr... View the full answer