Maturity Clienteles in the Municipal Bond Market: Term Premiums and the Muni Puzzle

Abstract

This paper finds empirical support for the idea that term premiums arise when an excess supply of long-term bonds forces shorter holding period investors to bear price risk. The empirical support comes from the tax-exempt (municipal) bond market where an ex-ante measure of the expected excess return on long maturity bonds is significantly and negatively related to the size of the positions held by long holding period investors (property and casualty insurance companies) and hence negatively related to the extent that short holding period investors are required to hold long-term bonds. The required excess returns on longer term bonds (term premiums) would cause implied marginal tax rates to decline with maturity and thus are a new potential explanation for at least part of the “muni puzzle” (Chalmers, 1998).