How Deferred Bond Taxes Can Raise After-Tax Yield

Summary

The question compares the yield on a bond under three tax treatments: no tax, tax applied to coupon income and the gain, and tax deferred until the bond matures. It gives present-value equations for each case and an example with a bond priced below par, a fixed coupon, a ten-year term, and a stated tax rate. In that example, the calculated yield is higher when tax is deferred than when tax is paid immediately.

The intuitive explanation is that deferral leaves more of the investment’s value available to earn returns for longer, so the tax payment’s timing affects the investor’s cash flows and annualized yield. The document asks whether this amounts to earning interest on the deferred tax, but it contains no accepted answer or derivation resolving the question. Its formulas and numerical results are presented by the questioner and are not independently checked here; the conclusion depends on the assumed tax basis, timing, and cash-flow treatment. It is an illustration of tax timing, not a general bond-tax calculation guide.

Key ideas

• The document compares bond yields under immediate taxation and taxation deferred until maturity.
• Its example reports a higher calculated after-tax yield when tax payment is deferred.
• The timing of tax payments changes the investor’s cash flows and can affect annualized yield.
• The excerpt does not provide a derivation or verify the equations and reported calculations.
• The result depends on the tax basis and cash-flow assumptions used in the model.

Tags

# Why do we get a higher yield when we pay the interest at the end?(bonds)


# Why do we get a higher yield when we pay the interest at the end?(bonds)












I have an example where I show that if you pay the tax at the end of the bond period, the yield after tax is higher, but I am wondering if it is possible to give an explanation as to why it is like this? I am looking for both intuitive and mathematical answers, the expressions becomes so messy I am not able to show it myself.

Here is the example.

case no tax Assume first that we look at the bond without tax, then we get the expression:

$$PV = \sum\limits_{i=1}^N\frac{100r}{(1+y)^i}+\frac{100}{(1+y)^N},$$

with $PV=99, r= 5\%, N = 10$ we can solve it numerically to get $y=5,13\%$ if I have solved it correctly.

case tax immediately

Now the equation becomes

$$PV = \sum\limits_{i=1}^N\frac{100r(1-Tax)}{(1+y_2)^i}+\frac{100-(100-PV)*Tax}{(1+y_2)^N}$$

by using $PV=99, r=5\%, Tax = 25\%, N=10$ we get $y_2=3,85 \%.$

case deferred tax

Now the equation becomes

$$PV = \sum\limits_{i=1}^N\frac{100r}{(1+y_3)^i}+\frac{100-(100-PV)*Tax-N*100*r*Tax}{(1+y_3)^N},$$ now $y_3= 4,07 \%.$

conclusion

We see that with the deferred tax situation the yield after tax is higher. But can one explain this in some way? I suspect one explanation is that since we defer it we are able to get interest interest on the tax in some way, but I am not able to show it, is this the case that makes the return higher?, if so, how is it shown, or is there another explanation?

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.