Liquidity, Default, Taxes and Yields on Municipal Bonds

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