Keywords: Municipal bond, liquidity risk, default, tax rate, yield spread
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.
Full paper (222 KB PDF)
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Last update: September 1, 2005