DETERMINANTS OF THE DECREASING TERM STRUCTURE OF RELATIVE YIELD SPREADS FOR TAXABLE AND TAX-EXEMPT BONDS

The empirical finding that the relative yield spread for taxable and t ax-exempt bonds decreases across the term structure is usually attribu ted to tax differentials and/or arbitrage opportunities. Using monthly data, it is found that the decreasing term structure of relative yiel d spreads is determined by the decreasing forward marginal tax rate; i ncreasing default risk premium; increasing tax-timing option premium; and expected rate of inflation.