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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 shortterm municipal securities have remained relatively 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 generically to characterize all short- or long-term bonds
issued by a variety of governmental bodies. General 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 agencies providing transit, public utility, irrigation,
housing or other services that receive income
from those services. As their name implies, revenue bonds rely upon the flow of revenues from
the specific services provided to retire outstanding debt.
to another level of government without enacting
specially tailored legislation or programs.
Influences on municipal yields
Because the interest on municipal bonds is taxfree, a major factor determining municipal bond
yields is the structure of income tax rates facing
bondholders. If a single marginal tax rate applied
to all taxpayers, otherwise identical taxable and
nontaxable bonds wou Id sell to yield equ ivalent
after-tax returns, and these returns would be ,
identical for all taxpayers. For example, if the tax
rate were universal at 50 percent, yields on municipal bonds would be roughly 50 percent of the
yields available from similar taxable issues.
Under a progressive income tax system, the
determination·of relative yields is potentially related in a more complex way to the tax structure. If
very few municipal bonds are issued, the highest
marginal tax rate in the economy will determine
relative yields. However, if the class of investors
subject to the highest marginal rate is unwilling
or unable to hold the entire outstanding stock of
municipal debt in its portfolio, the yield on municipal bonds (relative to taxable bonds) must rise
to attract investors at lower marginal tax rates. In
such a case, the relative yields of taxable and~
tax-exempt securities would depend not only on
the level of marginal tax rates, but also on the
outstanding supply of municipal debt and the
progressiveness of the tax rate structure. Thus, the
relationship between yields of otherwise identical taxable and tax-~xempt debt may react
sharply to reductions in marginal tax rates and
changes in the quantity of new municipal debt
issued.
Effects of recent tax reform
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 government, for example, is implicitly subsidizing governments and agencies when the interest on their
bond issues is not subject to federal taxes. State
and local governments and agencies thus find
issuing tax-exempt bonds attractive because the
bonds allow them to shift fiscal burdens partially
The major tax reforms initiated in 1981 altered
federal income tax rates significantly and thus
changed the relative desi rabi Iity of tax-exempt
and taxable bond income. Two tax changes in
particular may have contributed to the narrowing
of the yield spread.
First, marginal tax rates were reduced significantly for all taxable income brackets. The
decrease, phased in over a period of three years,
FRBSF
was 25 percent for most brackets but was almost
30 percent for the highest bracket as the maximum marginal tax rate on investment income
was cut from 70 to 50 percent (i.e., a 20 percentage point decline from 70 percent is a 28.6
percent decline). These changes alone would
result in a 25 to 30 percent narrowing of the
yield spread.
Second, marginal tax rates were indexed to inflation. This indexation did very little for the highest
income taxpayers because they were already
subject to the maximum marginal rate. However,
for taxpayers below the maximum rate, this
change reduced their anticipated marginal tax
rate position in future years.' By itself, this reduction also would tend to increase municipal bond
yields relative to the yields on similar taxable
issues. Its effects would add to those caused by
the basiccut in marginal tax rates and would be
most pronounced in the case of long-term (technically, long "duration") municipal bonds for
which anticipated changes in after-tax coupon
income are more important.
The recent trends in the relationship between
taxable and tax-exempt bond yields is consistent
with these hypothesized effects. The yields on
long-term municipal bonds, which were approximately 66 percent of the yields of thei r taxable
counterparts in mid-1979, had risen to as much
as 95 percent by the end of 1982. On the basis of
the 25 percent tax cut alone, only an increase to
around 75 percent would have been expected.
The relationship between the yields of prime
grade short-term (one year) municipal securities and their close taxable counterparts, however, changed less dramatically. The tax-exempt
yields rose from 51 percent to 59 percent of the
taxable yield in the same time period. This
change is roughly consistent with the 25 percent
reduction in the effective marginal tax rate alone.
(See chart.)
Supply effects
The discussion above suggests that increases in
the outstanding stock of municipal securities also
wou Id tend to narrow the spread between taxable
and nontaxable yields. In the late 1970s and early
1980s, many state and local governments reacted
to the damaging effects of the high interest rate
environment on sectors such as housing and
local industrial development by issuing municipal bonds to those markets. The bonds allowed
state and local governments implicitly to wrest
a subsidy from the federal government.
Mortgage revenue bonds were a particularly
widely used device to assist in providing belowmarket mortgage funds to housing developers
and homeowners.
Although the federal government-through the
Mortgage Subsidy Bond Tax Act -placed limits
on the volume of tax-exempt mortgage revenue
bonds that could be issued, this type of bond
nevertheless significantly added to the total
supply of municipal bonds. (In California, for
example, mortgage revenue bonds in 1984 constituted about 25 percent of all long-term state
and local debt issued annually, and represented a
large addition to traditional municipal borrowing.) For taxpayers to hold additional municipal
bonds in their portfolio willingly, the yields on
those bonds had to rise to attract households in
lower marginal tax rates.
Changes in 1984
This explanation, based on the increased volume
of municipal bonds, also is consistent with the
temporary increase in relative yield spreads that
occurred in early 1984 and the subsequent precipitous decline later the same year. The Mortgage Subsidy Bond Tax Act expired in 1983 and
left state and local governments without authority
to issue mortgage revenue bonds exempt from
federal income taxation. The Act was reinstated
in June 1984, however, and the flow of new
mortgage revenue bond issues abruptly returned
to earlier levels.
The Tax Act of 1984 also imposed caps on municipal bonds issued for "private activities" to take
effectJanuary 1, 1985. Many state and local
governments that wanted to issue the affected
bonds -mostly industrial development bondsreacted by rushing to do so before the end of
1984. The result was a total of new municipal
debt issued in 1984 that exceeded the 1983 level
by over 20 percent. This rush, therefore, also may
have contributed to the depression in yield
spreads observed at the end of 1984.
Other contributing factors
The structure of marginal tax rates and the volume
of new municipal debt issues are not the only
factors, of course, that determine the relationship
between taxable and nontaxable yields. Some
observers have argued, for example, that risk
considerations also have affected relative yields.
It is, however, difficult to assess the effects of
financial difficulties encountered by some cities
and states in the 1970s on the market's perception of the default risk of municipal bonds.
Nevertheless, the mortgage bond insurance
industry -which insures bondholders against
loss resulting from default-has grown dramatically since the mid-1970s, suggesting that investor concern over default risk may indeed be
more widespread.
In addition, it is often pointed out that many
issuers of municipal debt during recent high
interest rate periods have included "call" features that allow them to call in the debt under
prespecified conditions. These features are attractive to the issuer because they allow the option to
refinance the debt at lower cost should interest
rates faiL (Mortgage revenue bonds, by federal
law, also contain a mandatory three-year call if
the funds cannot be invested in the projects
intended for their use before that time.) These
provisions, however, cause debtholders to demand a higher yield to compensate them for the
risk passed onto them by the call provisions.
Our analysis of municipal bond yields, which
attempts to control for the default risk and implicit call characteristics of municipal bonds,
indicates that these factors are insufficient to
explain the observed patterns of yield changes.
A final possible explanation for the narrowing
spread between taxable and municipal securities
is that the marketplace anticipates further limitations on the exemption of municipal bond income
from taxation. (This would be the case, for
example, if certain features of the recent Treasury
tax reform proposals were implemented.) Such
an anticipation would cause the yields on longterm municipal bonds to rise, but have little effect
on the yields of short-term municipal debt, a
result consistent with the observed pattern of relative yields. This explanation seems unlikely,
however, because the major changes in the relative yields of taxable and nontaxable debt
occurred between 1980 and 1982, beforesuch
tax reforms gained wide currency.
Yields on Municipal Securities as
Percent of Yields on Taxable Securities
Percent
95
90
85
80
75
AAA Municipal Bonds
20.Year T.Bonds
70
65
60
55
50
45
40 '----'------'------'----'----'----'-----'-----"
1978 1979 1980 1981 1982 1983 1984 1985
Source: Standard and Poor's, Salomon Brothers, Federal Reserve
Implications for financial markets
The explanations offered here for the recent behavior of municipal bond yields implies that, for
some reason, the taxpayers subject to the highest
marginal tax rate are unwilling or unable to hold
the entire stock of tax-exempt securities. Their
rei uctance may be due to the effectiveness of
Internal Revenue Service provisions restricting
the ability of taxpayers to borrow to finance municipal bond purchases. (If this were not the case,
high tax rate households and corporations would
be able to increase their after-tax income by deducting the interest on borrowed funds while enjoying tax-exempt income from municipal bond
holdings.) Transactions costs also may make it
difficult for investors to restructure their portfolios
quickly in response to changes in the relative
yields of various securities.
Whatever the explanation, our analysis suggests
thatthe long-term municipal bond market will
continue to be highly sensitive to changes in tax
policy and the supply of municipal securities.
Such behavior creates interesting challenges and
opportunities for municipal borrowers and private investors alike.
RandallJ.Pozdena
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author •..• Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments 1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities 2
Other Securities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances 4
Total Non-Transaction Balances 6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed Money5
Two Week Averages
of Daily FigureS
Amount
Outstanding
Change
from
02/06/85
188,161
170,058
52,286
62,015
32,471
5,289
11,037
7,065
193,727
44,964
29,697
13,227
135,536
01/30/85
-
-
-
Change from
02/08/84
Dollar
959
983
288
10
8
13
1
26
1,491
928
620
768
205
-
7.4
9.8
12.9
4.4
21.3
5.2
- 10.0
- 10.9
5.4
6.6
3.4
8.4
4.7
43,433
45
3,424
8.5
39,319
19,617
11
-1,832
1,147
799
3.0
4.2
Penodended
Penodended
01/28/85
01/14/85
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency (- )
Borrowings
Net free reserves (+ )/Net borrowed( - )
1
2
3
4
5
6
7
Percent?
13,089
15,191
5,999
2,616
5,694
263
1,229
871
9,924
2,789
991
1,028
6,107
123
57
66
21
22
°
Includes loss reserves, unearned income, excludes interbank loans
Excludes trading account securities
Excludes U.S. government and depository institution deposits and cash items
ATS, NOW, Super NOW and savings accountS with telephone transfers
Includes borrowing via FRB, TI&L notes, Fed Funds, RPs and other sources
Includes items not shown separately
Annualized percent change
@FedFRASER