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Liquidity, default, taxes and yields on municipal bonds

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  • Junbo Wang
  • Chunchi Wu
  • Frank Zhang
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    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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    Bibliographic Info

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

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    Keywords: Municipal bonds ; Liquidity (Economics);

    This paper has been announced in the following NEP Reports:

    References

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    7. Amihud, Yakov & Mendelson, Haim, 1986. "Asset pricing and the bid-ask spread," Journal of Financial Economics, Elsevier, vol. 17(2), pages 223-249, December.
    8. 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.
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    10. Wu, Chunchi, 1991. "A Certainty Equivalent Approach to Municipal Bond Default Risk Estimation," Journal of Financial Research, Southern Finance Association & Southwestern Finance Association, vol. 14(3), pages 241-47, Fall.
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    18. Miller, Merton H, 1977. "Debt and Taxes," Journal of Finance, American Finance Association, vol. 32(2), pages 261-75, May.
    19. James M. Poterba, 1986. "Explaining the Yield Spread between Taxable and Tax-exempt Bonds : The Role of Expected Tax Policy," NBER Chapters, in: Studies in State and Local Public Finance, pages 5-52 National Bureau of Economic Research, Inc.
    20. 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.
    21. Ang, James & Peterson, David & Peterson, Pamela, 1985. " Marginal Tax Rates: Evidence from Nontaxable Corporate Bonds: A Note," Journal of Finance, American Finance Association, vol. 40(1), pages 327-32, March.
    22. Constantinides, George M. & Ingersoll, Jonathan Jr., 1984. "Optimal bond trading with personal taxes," Journal of Financial Economics, Elsevier, vol. 13(3), pages 299-335, September.
    23. Chris Downing & Frank Zhang, 2004. "Trading Activity and Price Volatility in the Municipal Bond Market," Journal of Finance, American Finance Association, vol. 59(2), pages 899-931, 04.
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