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A Simple Model of the Taxable and Tax-Exempt Yield Curves

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  • Green, Richard C

Abstract

I examine the anomalous behavior of the taxable and tax-exempt yield curves. Long municipal yields appear too high relative to the equivalent after-tax yield that can be earned in Treasury or corporate bonds. I discuss existing explanations of the problem and propose a simple model that relates the yields of taxable bonds to the yield curve for par tax exempts. The ratio of the tax-exempt yield to the taxable yield increases with maturity in the model, so it is consistent with observed phenomena such as inverted yield curves for taxables and contemporaneous rising yield curves for tax exempts. Statistical and descriptive comparisons between the yields predicted.by the model and observed yields on par bonds that the model has some promise in explaining the apparent anomalies in the behaviors of the two yield curves. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

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Bibliographic Info

Article provided by Society for Financial Studies in its journal Review of Financial Studies.

Volume (Year): 6 (1993)
Issue (Month): 2 ()
Pages: 233-64

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Handle: RePEc:oup:rfinst:v:6:y:1993:i:2:p:233-64

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Cited by:
  1. N. Gregory Mankiw & James Poterba, 1996. "Stock-Market Yields and the Pricing of Municipal Bonds," Harvard Institute of Economic Research Working Papers 1761, Harvard - Institute of Economic Research.
  2. Frank Milne & Xing Jin, 2006. "Taxation and Transaction Costs in a General Equilibrium Asset Economy," Working Papers 1111, Queen's University, Department of Economics.
  3. Richard C. Green & Burton Hollifield & Norman Schurhoff, . "Financial Intermediation and the Costs of Trading in an Opaque Market," GSIA Working Papers 2004-11, Carnegie Mellon University, Tepper School of Business.
  4. Poterba, James M. & Verdugo, Arturo Ramírez, 2011. "Portfolio Substitution And The Revenue Cost Of The Federal Income Tax Exemption For State And Local Government Bonds," National Tax Journal, National Tax Association, vol. 64(2), pages 591-613, June.
  5. Robert Novy-Marx & Joshua D. Rauh, 2012. "Fiscal Imbalances and Borrowing Costs: Evidence from State Investment Losses," American Economic Journal: Economic Policy, American Economic Association, vol. 4(2), pages 182-213, May.
  6. Phillip Daves & Michael Ehrhardt, 2011. "Creating a synthetic after-tax zero-coupon bond using US Treasury STRIP bonds: implications for the true after-tax spot rate," Applied Financial Economics, Taylor & Francis Journals, vol. 21(10), pages 695-705.
  7. Junbo Wang & Chunchi Wu & Frank Zhang, 2005. "Liquidity, default, taxes and yields on municipal bonds," Finance and Economics Discussion Series 2005-35, Board of Governors of the Federal Reserve System (U.S.).
  8. Cestau, Dario & Green, Richard C. & Schürhoff, Norman, 2013. "Tax-subsidized underpricing: The market for Build America Bonds," Journal of Monetary Economics, Elsevier, vol. 60(5), pages 593-608.

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