Liquidity, default, taxes, and yields on municipal bonds

Research output: Journal Publications and Reviews (RGC: 21, 22, 62)21_Publication in refereed journalpeer-review

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Author(s)

Detail(s)

Original languageEnglish
Pages (from-to)1133-1149
Journal / PublicationJournal of Banking and Finance
Volume32
Issue number6
Publication statusPublished - Jun 2008

Abstract

We examine the effects of liquidity, default and personal taxes on the relative yields of Treasuries and municipals using a generalized model with liquidity risk. The municipal yield model includes liquidity as a state factor. Using a unique transaction dataset, we estimate the liquidity risk of municipals and its effect on bond yields. Empirical evidence shows that municipal bond yields are strongly affected by all three factors. The effects of default and liquidity risk on municipal yields increase with maturity and credit risk. Liquidity premium accounts for about 9-13% of municipal yields for AAA bonds, 9-15% for AA/A bonds and 8-19% for BBB bonds. A substantial portion of the maturity spread between long- and short-maturity municipal bonds is attributed to the liquidity premium. Ignoring the liquidity risk effect thus results in a severe underestimation of municipal bond yields. Conditional on the effects of default and liquidity risk, we obtain implicit tax rates very close to the statutory tax rates of high-income individuals and institutional investors. Furthermore, these implicit income tax rates are quite stable across bonds of different maturities. Results show that including liquidity risk in the municipal bond pricing model helps explain the muni puzzle. © 2007 Elsevier B.V. All rights reserved.

Research Area(s)

  • Default risk, Liquidity risk, Maturity spreads, Municipal bond yields, Tax-exemption

Citation Format(s)

Liquidity, default, taxes, and yields on municipal bonds. / Wang, Junbo; Wu, Chunchi; Zhang, Frank X.
In: Journal of Banking and Finance, Vol. 32, No. 6, 06.2008, p. 1133-1149.

Research output: Journal Publications and Reviews (RGC: 21, 22, 62)21_Publication in refereed journalpeer-review