Did Tax Reform Kill Segmentation in the Municipal Bond Market?

Abstract

The net return to an investor in tax-exempt municipal is determined by two things: the yield on comparable taxable and the investor's tax rate. The flurry of tax reform legislation in the 1980s resulted in significant changes in the latter, and, as a result, it caused significant changes in the municipal bond market. One of the most important was the removal of tax preferences for commercial banks that bought and held municipal securities. In 1980, the banking sector was the largest investor in the market, holding 39 percent of all outstanding issues. As a result of the removal of the tax preferences, the banking sector has been a net seller of municipal ever since the middle of 1986. By mid-1992 banks held only 9 percent of all issues. During die same period, however, exempt mutual funds and exempt money market funds increased their holdings from near zero to over 20 percent of all outstanding issues. Not only does the withdrawal of the banking sector from the market deprive issuers of an important customer, but it also has important implications for our understanding of how tax-exempt yields (interest rates) are determined. Prior to the mid-1980s, the municipal bond market was characterized by segmentation, or the existence of separate internal markets.(1) Specifically, the primary market for short-term debt was the commercial banking sector while the primary market for long-term debt was the household, or individual, sector. As a result of segmentation, short- and long-term bond yields were determined by different factors. Short-term yields were influenced by bank demand and the corporate tax rate that banks faced, whereas long-term yields were determined by individual demand and the personal tax rate faced by the marginal individual buyer. Because household and bank demand were influenced by different factors, and because the two tax rates were not equal, yields on short- and long-term tax-exempt were often very different.(2) Despite the fact that banks have been net sellers of municipals for the past seven years, W.B. Hildreth recently noted that, Issuers now develop debt issuance plans based on current and prospective investors' interest because the segmentation of the municipal market means that investor clienteles are different for short- and long-maturity bonds (1993, p. 45). The basis of this statement is research that was conducted in the early 1980s and that refers to the theory of segmentation.(3) However, the theory, based as it is on different bank and individual tax rates and demand, cannot be valid for short-term issues in the current environment where banks are no longer major players in the market. If observers and practitioners are to understand their market and develop effective debt issuance plans, it is necessary to determine if there are still different investor clienteles, and if so, if a different form of market segmentation now exists. Similar to the banking sector, exempt money market funds prefer short-term securities. It follows that a logical place to begin a search for an alternative theory of segmentation is by examining the changes in the short-term market and the subsequent effects of the growth of the money markets. Such a search is the subject of this article. The Existing Theory of Segmented Markets If two are similar in all ways except that the interest on one is taxable and the interest on the other is tax exempt, then the after tax yields should be equal. For example, if the relevant tax rate is 30 percent and taxable pay 10 percent interest, then a comparable exempt bond should pay 7 percent. Formally, if the yield on taxable able and exempt are [Y.sub.t] and [Y.sub.e] respectively, and the tax rate is equal to [tau], then [Y.sub.e] = (1 - [tau]) [Y.sub.t], or [Y.sub.e]/[Y.sub.t] = (1 - [tau]), where [Y.sub.e]/[Y.sub.t] is referred to as the yield ratio. …