Tax-free bond yield curve steep / taxable bond curve flatter

Has anyone an explanation for that: tax-free bond yield curve steep / taxable bond curve flatter?


Any answer to this question? Thank you!

Seems odd. I’d expect it to be the other way round.

Where’d you encounter this?

It is under the Return objective of the Non-Life Insurance Company Objectives. They mentioned that that when they introduce the “underwriting or profitability cycle”.

"When profitable, companies will pay taxes and may find it attractive to shift investments out of taxable bonds and into-tax-exempt bonds. While tax-exempt bonds have a lower yield, the untaxed return is higher than an after-tax return on taxable bonds. However, the tax-exempt yield curve tends to be relatively steeper than the yield curve for taxable bonds. This creates an inducement to buy longer tax-exempt bonds and increase asset duration for higher expected return. "

Thank you!

it is I believe the effect of the tax. If you take a taxable bond - you are getting a yield of say 5% paying 20% tax - so effective yield is 5*(1-0.2) = 4%. However a Tax Exempt bond with a yield of 5% is exactly 5% - so the yield curve of tax exempt bond is steeper than that of a taxable bond … (same maturity, and same yield on both bonds).

Under that interpretation − comparing the pretax yields of taxable bonds vs. tax-exempt bonds − it makes sense that the tax-exempt yield curve would be flatter.

Agree with s2000 because I’d think the tax treatment differential would be priced in by the market. Hell, I’m super curious to know why CFAI makes this claim. Seems to me its pointless to buy a taxable bond if I can get more yield out of a out of a taxfree. Why not just short the taxable and buy the taxfree?

Thank you all for the help!! I guess this is simple concept I overthought.