Optimal Trading and Tax Option Value of Defaultable Bonds with Asymmetric Capital Gain Taxes

Abstract

Current U.S. tax laws provide investors an incentive to time the sales of their bonds to minimize tax liability. Interest income and short-term capital gains are subject to higher tax rates than long-term capital gains. These differential tax treatments affect investors' trading strategies and give rise to a tax timing option that affects bond value. In reality, corporate bond investors' tax-timing strategy is complicated by the risk of default. How much corporate bond value is derived from the tax-timing option is unknown. Existing term structure models of corporate bonds have completely ignored the effect of the tax-timing option on bond yields. In this paper we examine the effects of taxes on the timing option value and equilibrium bond price by accounting for discount and premium amortization, multiple trading dates, transaction costs, and changes in the level and volatility of interest rates. We find that tax timing option value accounts for a sizable fraction of corporate bond price. The tax timing option value ranges from 15% to 24% for bonds with maturity longer than 20 years when the level of interest rate is high. The timing option value remains sizable, ranging from 10% to 16%, even in an environment with low interest rates and volatility (1%). Ignoring the timing option value thus leads to a considerable overestimation of credit spread for long-term bonds. From the empirical perspective, ignoring the tax-timing option value results in underestimation of default probability and marginal income tax rate. These downward biases increase with bond maturity and decrease with bond quality.