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Liquidity, Default, Taxes and Yields on Municipal Bonds

Chunchi Wu

Universtity at Buffalo

Junbo Wang

City University of HongKong

Frank Xiaoling Zhang

Morgan Stanley

March 14, 2006

FEDS Working Paper No. 2005-35

We examine the effects of liquidity, default and personal taxes on the relative yields of Treasuries and municipals using a generalized model with liquidity risk. The municipal yield model 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. Empirical evidence indicates that municipal bond yields are strongly affected by liquidity risk, default and taxes. The effects of default and liquidity risk on municipal yields increase with maturity and credit risk. Liquidity premium explains about 7 to 13 percent of municipal yields for AAA bonds, 7 to 16 percent for AA/A bonds and 8 to 20 percent for BBB bonds. A substantial portion of the maturity spread between long- and short-maturity municipal bonds is attributed to the liquidity premium. Ignoring the liquidity risk effect thus results in an underestimation of municipal bond yields. 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. Furthermore, these implicit income tax rates are remarkably stable over maturities. Results show that the generalized model with liquidity risk explains the behavior of Treasury and municipal yield curves very well.

Number of Pages in PDF File: 51

Keywords: liqudity, default, taxes, yields, maturity, municipal bonds

JEL Classification: G0, G1

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Date posted: March 23, 2005  

Suggested Citation

Wu, Chunchi and Wang, Junbo and Zhang, Frank Xiaoling, Liquidity, Default, Taxes and Yields on Municipal Bonds (March 14, 2006). FEDS Working Paper No. 2005-35 . Available at SSRN: http://ssrn.com/abstract=687500 or http://dx.doi.org/10.2139/ssrn.687500

Contact Information

Chunchi Wu (Contact Author)
Universtity at Buffalo ( email )
School of Management
335A Jacobs Management Center
Buffalo, NY 14260
United States
Junbo Wang
City University of HongKong ( email )
88 Tat Chee Ave.
Kowloon Town
Hong Kong
Hong Kong
852-2788-7243 (Phone)
852-2788-8806 (Fax)
Frank Xiaoling Zhang
Morgan Stanley ( email )
1585 Broadway
New York, NY 10036
United States
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