Stock Market Yields and the Pricing of Municipal Bonds

22 Pages Posted: 1 Jul 2000 Last revised: 25 Mar 2008

See all articles by N. Gregory Mankiw

N. Gregory Mankiw

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

James M. Poterba

National Bureau of Economic Research (NBER); Massachusetts Institute of Technology (MIT) - Department of Economics

Date Written: June 1996

Abstract

This paper proposes an alternative to the traditional model for explaining the spread between taxable and tax-exempt bond yields. This alternative model is a special case of a general class of clientele models of portfolio choice and asset market equilibrium. In particular, we consider a setting with two types of investors, a taxable investor and a tax-exempt investor, who hold specialized bond portfolios. The tax-exempt investor holds only taxable bonds, and the taxable investor holds only tax-exempt bonds. Both investors hold equity, and the taxable and tax-exempt bond markets are linked through the equilibrium conditions governing equity holding and bond holding for each type of investor. In contrast to the traditional model, this alternative model has the potential to explain the small observed spread between taxable and tax-exempt yields. In addition, this model predicts that the yield spread between taxable and tax-exempt bonds should be an increasing function of the dividend yield on corporate stocks. Although the substantial changes in the tax code during the last four decades complicate the testing of this model, we find some support for the predicted relationship between the equity dividend yield and the yield spread between taxable and tax-exempt bonds.

Suggested Citation

Mankiw, N. Gregory and Poterba, James M., Stock Market Yields and the Pricing of Municipal Bonds (June 1996). NBER Working Paper No. w5607. Available at SSRN: https://ssrn.com/abstract=225545

N. Gregory Mankiw (Contact Author)

Harvard University - Department of Economics ( email )

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James M. Poterba

National Bureau of Economic Research (NBER) ( email )

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