The Relative Yields of Tax-Exempt and Taxable Bonds: Evidence from Municipal Bonds that are Secured by U.S. Treasury Obligations

Posted: 22 Aug 1998

Abstract

Fama (1977) and Miller (1977) predict that one minus the corporate tax rate will equate the after-tax yield from a taxable bond to the tax-exempt yield. This prediction is not rejected for short maturity tax-exempt and taxable bonds. However, at long maturities the yields on tax-exempt bonds are higher than predicted by the theory. A popular explanation for this empirical fact is that municipal bonds bear more default risk than comparable taxable bonds. A sample of municipal bonds that are secured by irrevocable escrows of U.S. Treasury securities is used to examine the relation between taxable and tax-exempt yields. The results show that default-free tax-exempt yields display the same tendency to be too high relative to the Fama and Miller prediction. This fact implies that differential default risk does not explain relatively high yields on long-term tax-exempt bonds. This paper also documents a curious fact. U.S. Government secured municipal bonds have higher yields than comparable maturity AAA rated municipal bonds that are not secured by U.S. Treasury bonds.

JEL Classification: G10, H74

Suggested Citation

Chalmers, John, The Relative Yields of Tax-Exempt and Taxable Bonds: Evidence from Municipal Bonds that are Secured by U.S. Treasury Obligations. Available at SSRN: https://ssrn.com/abstract=6903

John Chalmers (Contact Author)

University of Oregon ( email )

Lundquist College of Business
1208 University of Oregon
Eugene, OR 97403
United States
541-346-3337 (Phone)

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