A Pure Test for the Elasticity of Yield Spreads

which apply to U.S. corporate and Treasury bonds. Duffee (1998) notes that U.S. corporate
bonds are subject to taxation at the federal, state, and local levels, while U.S. Treasury bonds
are subject only to federal tax.⁴ To determine the potential effect of these distortions on credit
spreads, Elton et al. (2001) decompose yield spreads (calculated from estimated zero curves)
for U.S. investment-grade corporate bonds into three components: default-risk premium,
systematic-risk premium, and a state-tax premium. Their analysis shows that the state-tax
premium is significantly more important relative to the default-risk premium (36.1 percent
versus 17.8 percent of the yield spread for 10-year A-rated bonds, respectively). Since
Canadian corporate and Government of Canada bonds are subject to an identical tax rate
then tax effects should not play a role in the estimated relation for Canadian corporate bonds
and their spreads.

Another advantage of using the Canadian bond data relates to both the level of
coupons and the tax system. Constantinides and Ingersoll (1984) show that a dynamic bond
trading strategy, aimed at minimizing tax liabilities, produces bond prices significantly
higher than when using a buy-and-hold strategy. They attribute this difference in value to the
tax-timing option. Jordan and Jordan (1991) provide strong evidence supporting the
existence of a tax-timing option for U.S. Treasury bonds.

Prisman, Roberts, and Tian (1996) demonstrate that, given the different tax treatment
for bonds in Canada, the tax-timing option in Canada is unlikely to have an economic value
to bond traders. In addition, they show that when the range of coupon rates in the portfolio
contracts, the value of the tax-timing option will be even lower. Historically, SCM (Scotia
Capital Markets) imposed constraints on the range of coupon rates permitted for corporate
bonds to be included in its indices.⁵ These constraints were designed to eliminate the coupon
level effect from the yield spread of the included bonds over the yield on Government of
Canada bonds, so that this spread is as close as possible to the true yield spread. Given these
constraints, and the tight range of coupon rates at the present, the value for the tax-timing
option for these indices is expected to be even lower, and its impact on the estimated relation

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