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Municipal bond behavior

  • Agricultural Science
  • Political Science


FRBSF WEEKLY LETTEA February 22, 1985 Municipal Bond Behavior One of the more intriguing developments in financial markets in recent years has been the marked narrowing in the spread between the yields of taxable and nontaxable ("municipal") long-term bonds. This spread has declined by as much as two-thirds since the late 1970s. Recent issues of municipal bonds have sold with yields that are as much as 90 or 95 percent of the yields on comparable, fully taxable bonds. In contrast to these developments for long-term securities, the relative yields on short-term taxable and short- term municipal securities have remained rela- tively stable, with the latter yielding between 50 and 60 percent of their taxable counterparts. There are a number of possible explanations for these patterns of yield changes. This Letter examines the various hypotheses and discusses their implications for the operation of financial markets. Nontaxable debt The term "municipal bond" often is used generi- cally to characterize all short- or long-term bonds issued by a variety of governmental bodies. Gen- eral obligation bonds, for example, are a class of taxable bonds issued typically by municipal, county or state governmental bodies with the authority to obligate general tax revenues to retire the bonds. Revenue bonds, on the other hand, typically are issued by special districts or agen- cies providing transit, public utility, irrigation, housing or other services that receive income from those services. As their name implies, rev- enue bonds rely upon the flow of revenues from the specific services provided to retire out- standing debt. The decision to exempt the coupon income from a particular bond from taxation in essence is a decision to subsidize the activity of the issuing level of government. Thus, the federal govern- ment, for example, is implicitly subsidizing gov- ernments and agencies when the interest on their bond issues is not subject to federal taxes. State and local governments and agencies thus find

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