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Finance and Economics Discussion Series
Finance and Economics Discussion Series logo links to FEDS home page Liquidity, Default, Taxes and Yields on Municipal Bonds
Junbo Wang, Chunchi Wu, and 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.

Keywords: Municipal bond, liquidity risk, default, tax rate, yield spread

Full paper (222 KB PDF)

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Last update: September 1, 2005