The Relative Price Volatility of Taxable and Non‐Taxable Bonds: A Note

Abstract

BECAUSE THE YIELDS TO maturity on municipal bonds are generally more volatile than the yields on taxable bonds, previous authors have concluded that the prices of municipal bonds are also more volatile.' This paper shows that this conclusion does not follow. The highly volatile nature of municipal bond prices is generally attributed first to the institutional phenomenon that, for banks, loans dominate municipal bonds as assets and secondly to the manner in which municipals are taxed.2 The institutional explanation for the greater price volatility of municipals is that banks prefer loans to municipals as investments on account of the special nature of the bank-customer relationships, namely that a customer may be both a depositor and a borrower. Therefore, in periods of expansionary monetary policy and slack loan demand, banks enter the market with funds and bid up municipal bond prices. During periods of restrictive monetary policy, deposits grow more slowly relative to loan demand and banks, having little or no excess funds to invest in municipals, withdraw from the municipal bond market. Thus, it is contended that commercial banks, the owners of approximately 45 percent of outstanding municipals [1], sell municipals when interest rates are rising and buy them when interest rates are falling, accentuating the cyclical swings in municipal bond prices. The tax explanation of municipal bond price volatility rests upon the argument that the yield volatility of municipals is increased by their special tax treatment.3