Liquidity and the Pricing of Municipal Bonds

We study the effect of liquidity risk on the relative yields on municipal and taxable bonds. We employ a reduced-form model with liquidity intensity and taxes to price tax-exempt bonds. Using a unique transaction dataset, we directly estimate marginal tax rate and liquidity intensity from observed data for insured municipal bonds. The empirical estimate of the marginal tax rate is consistent with the statutory income tax rate of wealthy individuals. More importantly, we find that a substantial portion of the yield spread between municipal and taxable bonds is attributable to the liquidity premium. Results show that including liquidity risk in the municipal bond pricing model helps explain the muni puzzle