Government Bonds

The biggest borrower in the world—by a wide margin—is everybody's favorite family member, Uncle Sam. In 2001, the total debt of the U.S. government was $5.6 trillion, or about $20,000 per citizen. When the government wishes to borrow money for more than one year, it sells what are known as Treasury notes and bonds to the public (in fact, it does so every month). Currently, Treasury notes and bonds have original maturities ranging from 2 to 30 years.

Most U.S. Treasury issues are just ordinary coupon bonds. Some older issues are callable, and a very few have some unusual features. There are two important things to keep in mind, however. First, U.S. Treasury issues, unlike essentially all other bonds, have no default risk because (we hope) the Treasury can always come up with the money to make the payments. Second, Treasury issues are exempt from state income taxes (though not federal income taxes). In other words, the coupons you receive on a Treasury note or bond are only taxed at the federal level.

State and local governments also borrow money by selling notes and bonds. Such issues are called municipal notes and bonds, or just "munis." Unlike Treasury issues, munis have varying degrees of default risk, and, in fact, they are rated much like corporate issues. Also, they are almost always callable. The most intriguing thing about munis is that their coupons are exempt from federal income taxes (though not state income taxes), which makes them very attractive to high-income, high-tax bracket investors.

Because of the enormous tax break they receive, the yields on municipal bonds are much lower than the yields on taxable bonds. For example, in May 2001, long-term Aa-rated corporate bonds were yielding about 6.72 percent. At the same time, long-term Aa munis were yielding about 4.87 percent. Suppose an investor was in a 30 percent tax

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

III. Valuation of Future Cash Flows

7. Interest Rates and Bond Valuation

© The McGraw-Hill Companies, 2002

CHAPTER 7 Interest Rates and Bond Valuation

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