Bond Interest in Terms of Cost of Capital versus Investor Yields
In the bond markets, a bond is that debt security in which a debt is owed to a bondholder by the bond issuer with an obligation of paying interest at a later date as soon as it matures. There are numerous types of a debt security, including corporate bonds and municipal bonds. For the corporate bonds, they are debt security that is issued by a specific firm or company along with timely marketing advertisements in the bond market and later sold to investors (Houweling, Patrick, & Jeroen, 2017). The firm dealing in the corporate bond first gets the necessary capital, in return, the investors are paid initially established payments as bond interest either at a variable or fixed rate of interest (Hakkio, & Smith, 2017). During the bond issuing, both the cost of investment equity and the cost of debts are taken into account. Besides, the required rate of return on the investments remains a justification for the risk that is barred by the investor. Such risks result in a rate of return required alongside the investor yields at the tune of the investor’s point of concern (Liang, et al., 2017).
For the investors in the bond markets, corporate bond interest is taxable as it attracts tax charges. Therefore, due to the taxation on the bond interest, the cost of bond interest be directly felt by the issuer of the bond. Moreover, alongside the cost impact of the bond interest, the tax impact is reducible by the tax relief and tax haven that is made available for expenses on bond interest in an attempt to boost the capital equity. Alongside the cost of capital, during the trading in bond interest, investor yields are considered as that yield receivable after holding a bond that is inclusive of both capital gains and interest income. For the yield to the investor in corporate bonds to be moderated, the investor must pay taxes on the interest income as well (Arslanalp, & Poghosyan, 2016). It, therefore, follows that any payment of tax on interest income reduces the actual yield to the investor.
However, unlike corporate bonds, municipal bonds are not taxable (Babina, et al., 2015). They are tax-free debt security and are not attracting any tax charges in the markets. The municipal bonds other than being issued by individual firms, they are issued by the municipality, state, or a county (Arslanalp, & Poghosyan, 2016). The tax-free nature of these bonds makes their effect in the bond market to be relatively dramatic as no direct tax impact is associated with them. Therefore, as municipal bonds are tax-free, the investor yields are incredible for there are no tax expenses to be incurred by the investor.
References
Arslanalp, S., & Poghosyan, T. (2016). Foreign investor flows and sovereign bond yields in advanced economies. Journal of Banking and Financial Economics, (2 (6)), 45-67.
Babina, T., Jotikasthira, C., Lundblad, C., & Ramadorai, T. (2015). Heterogeneous taxes and limited risk sharing: Evidence from municipal bonds. The Review of Financial Studies.
Hakkio, C. S., & Smith, A. L. (2017). Bond premiums and the natural real rate of interest. Economic Review, 102(1), 5-39.
Houweling, Patrick, & Jeroen V. Z. (2017) “Factor investing in the corporate bond market.” Financial Analysts Journal 73.2, 100-115.
Liang, J., Yin, H. M., Chen, X., & Wu, Y. (2017). On a corporate bond pricing model with credit rating migration risks and stochastic interest rate. Quanti Financ Econ, 1, 300-319.