The Effects of Statutory Portfolio Constraints on Tax-Exempt Interest Rates: Note

Abstract

1. lntroduction Whether or not the tax-exempt bond market is segmented is an issue of continuing controversy among academic researchers and market participants. The segmentation issue has been addressed on several levels, including studies of the effects of restrictions on bank entry in the underwriting of revenue bonds, the impact of private purpose revenue bonds on the cost of tax-supported state and local govemment bonds, and the effects of banks and bank demand on yield spreads within the tax-exempt market. Hendershott and Kidwell (1978), in a study particularly relevant for the present one, have offered empirical evidence suggesting that changes in the supply of securities issued by governmental units in one state relative to national new issue volume are associated with systematic changes in relative yields. Other studies (Forbes and Petersen 1975; Kaufman 1976; and Leonard 1983) have called attention to the persistence of yield differentials on tax-exempt bonds that differ only in the state or region of the issuer. While these studies suggest the possibility of geographic or local market segmentation, for the most part there have been few attempts to provide a rationale for the existence of such segmentation. This study attempts to fill the gap by analyzing the effects on tax-exempt interest rates of state laws that regulate both bank portfolio holdings of tax-exempts and the cash management practices of state and local governments (SLGs).