Suppose your local government decided to tax the interest income on its one bonds as parts of an efforts to rectify serious budgetary woes. What would you expect you see happen to the yields on these bonds?
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There would be a fast and brutal cashing-out process as people rushed to divest themselves of assets that are falling in price. With the advent of the Internet and independent reporting, government can't do this and feed off the uninformed as easily. I think the bonds would crash, possibly overnight, as people dumped them in favor of hard cash.
Obviously the profits of the bonds would go down and people would be very careful before placing their money in bonds in the future because of the way in which their profits would be whittled away more in bonds than they would in another form of investment, such as stocks.
As someone who's inclined to think that increasing taxes is rarely a good idea because governments have fewer incentives than businesses to use money wisely, I would assume that the increase in taxes would damage not only the value of the bonds in the present but also in the future since future tax increases might also be anticipated.
The bonds would be worth less, because the tax would eat up the profits. This would make the yield less as well. This would make the bond less attractive, which would mean that less people would be interested. In light of this, people may seek to put their money is stocks at this point. There usually is an inverse relationship.
If the bonds are taxed, they will come to be worth less. But what will this do to the yield? The price of the bond will go down because people know that the bond will be taxed and they'll be willing to pay less. So now the value will go down but the coupon amount will presumably stay the same. Therefore, the yield would actually go up.
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