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Liquidity, default, taxes and yields on municipal bonds

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Author Info
Junbo Wang
Chunchi Wu
Frank Zhang
Abstract

We examine the relative yields of Treasuries and municipals using a generalized model that includes liquidity as a state factor. Using a unique transaction dataset, we are able to estimate the liquidity risk of municipals and its effect on bond yields. We find that a substantial portion of the maturity spread between long- and short-maturity municipal bonds is attributable to the liquidity premium. Controlling for the effects of default and liquidity risk, we obtain implicit tax rates very close to the statutory tax rates of high-income individuals and corporations, and these tax rate estimates are remarkably stable over maturities.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2005-35.

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Date of creation: 2005
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Handle: RePEc:fip:fedgfe:2005-35

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Keywords: Municipal bonds ; Liquidity (Economics);

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  1. Edwin J. Elton, 2001. "Explaining the Rate Spread on Corporate Bonds," Journal of Finance, American Finance Association, vol. 56(1), pages 247-277, 02. [Downloadable!] (restricted)
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  3. Wu, Chunchi & Yu, Chih-Hsien, 1996. "Risk aversion and the yield of corporate debt," Journal of Banking & Finance, Elsevier, vol. 20(2), pages 267-281, March. [Downloadable!] (restricted)
  4. Stock, Duane, 1994. "Term structure effects on default risk premia and the relationship of default-risky tax-exempt yields to risk-free taxable yields -- a note," Journal of Banking & Finance, Elsevier, vol. 18(6), pages 1185-1203, December. [Downloadable!] (restricted)
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  6. Brennan, Michael J. & Subrahmanyam, Avanidhar, 1996. "Market microstructure and asset pricing: On the compensation for illiquidity in stock returns," Journal of Financial Economics, Elsevier, vol. 41(3), pages 441-464, July. [Downloadable!] (restricted)
  7. Pastor, Lubos & Stambaugh, Robert F., 2003. "Liquidity Risk and Expected Stock Returns," Journal of Political Economy, University of Chicago Press, vol. 111(3), pages 642-685, June. [Downloadable!] (restricted)
    Other versions:
  8. Poterba, J.M., 1989. "Tax Reform And The Market For Tax-Exempt Debt," Working papers 514, Massachusetts Institute of Technology (MIT), Department of Economics.
    Other versions:
  9. Kidwell, David S & Koch, Timothy W, 1983. "Market Segmentation and the Term Structure of Municipal Yields," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 15(1), pages 40-55, February. [Downloadable!] (restricted)
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  16. Amihud, Yakov, 2002. "Illiquidity and stock returns: cross-section and time-series effects," Journal of Financial Markets, Elsevier, vol. 5(1), pages 31-56, January. [Downloadable!] (restricted)
  17. Wu, Chunchi, 1991. "A Certainty Equivalent Approach to Municipal Bond Default Risk Estimation," Journal of Financial Research, Southern Finance Association and Southwestern Finance Association, vol. 14(3), pages 241-47, Fall.
  18. Miller, Merton H, 1977. "Debt and Taxes," Journal of Finance, American Finance Association, vol. 32(2), pages 261-75, May. [Downloadable!] (restricted)
  19. Bolder, David & Streliski, David, 1999. "Yield Curve Modelling at the Bank of Canada," Technical Reports 84, Bank of Canada. [Downloadable!]
  20. Green, Richard C & Odegaard, Bernt A, 1997. " Are There Tax Effects in the Relative Pricing of U.S. Government Bonds?," Journal of Finance, American Finance Association, vol. 52(2), pages 609-33, June. [Downloadable!] (restricted)
  21. Skelton, Jeffrey L, 1983. " Relative Risk in Municipal and Corporate Debt," Journal of Finance, American Finance Association, vol. 38(2), pages 625-34, May. [Downloadable!] (restricted)
  22. Jarrow, Robert A & Turnbull, Stuart M, 1995. " Pricing Derivatives on Financial Securities Subject to Credit Risk," Journal of Finance, American Finance Association, vol. 50(1), pages 53-85, March. [Downloadable!] (restricted)
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