Market Segmentation and the Term Structure of Municipal Yields

Abstract

AN ISSUE OF CONSIDERABLE CONTROVERSY in recent years is whether segmentation exists in the municipal bond market. The presence of market segmentation suggests that securities can be subdivided into distinct groups according to some characteristic and there exists a lack of substitution between these groups on the part of borrowers and/or investors [ 1, 4, 8] . Hendershott and Kidwell [4], for example, found evidence that market segmentation affected yields between regionally and nationally marketed municipal bond issues. Others contend that the municipal bond market is relatively efficient and no permanent segmentation effects can exist [2, 9]. Most recently, Campbell [2] examined possible segmentation resulting from the large acquisitions of municipal securities by commercial banks and found that bank demand for municipal securities had no significant influence on the yield spreads between municipal bonds which differed in default risk, term to maturity, and tax treatment. This is consistent with the argument that the combination of progressive personal income tax rates and fixed corporate income tax rates induces corporations to issue an amount of debt such that the marginal investor in taxable and tax-exempt securities pays taxes at the full corporate rate [9]. If segmentation does not exist, two peculiar features of the term structure of municipal yields cannot be fully explained. For one, municipal yields have almost always increased monotonically with maturity. This is true both for market averages of similarly rated municipal securities and for reoffering yields on individual serial