Tax-exempt Municipal Bonds Research Articles

The GFOA Certificate Revisited: Excellence in Financial Reporting and the Costs and Benefits of High Disclosure

We examine the relationship between disclosure as evidenced by the possession of the GFOA certificate for excellence in financial reporting (COA) and the cost of debt in the municipal bond market. Using a large database of tax-exempt municipal bonds issued by cities during 1994-2003, we find a statistically and economically significant relationship showing that disclosure reduces borrowing costs. We also find that compensation for city administrators and chief financial officers of cities attaining the COA is significantly higher than compensation for officials in cities without the COA. Overall, cities derive financial benefits that exceed the costs of obtaining the COA.

Does underwriter reputation matter in the municipal bond market?

We examine the role of underwriter reputation in the tax-exempt municipal bond market. Using a large sample of 10,239 tax-exempt municipal bonds, we show that generally, reputation matters. Municipal bond issues lead managed by larger and more prestigious underwriters have significantly lower borrowing costs, lower yields, and lower underwriting gross spreads. Our results are consistent with the view that reputation facilitates underwriter activities that leads to reducing information asymmetries between borrowers and issuers in the municipal bond market. Our results are also consistent with larger and more reputable underwriters providing a certificatory role for issues underwritten by them.

The Role and Impact of Financial Advisors in the Market for Municipal Bonds

Significantly more and more issuers of municipal bonds use the services of financial advisors during the bond issuance process. We investigate the benefits to issuers and market participants arising from the role of financial advisors in the issuance of municipal bonds. Using a large sample of 9493 tax-exempt municipal bonds, we show that financial advisors have significant impact on borrowing costs, reoffering yields and underwriter gross spreads. Our results are more pronounced for revenue bonds, particularly for negotiated revenue issues. In addition, our results show significant advantages to using a financial advisor for refunding issues supporting the view that financial advisors play important roles for more complex issues. Our results are consistent with the interpretation that financial advisors provide important and useful services resulting in monitoring and information asymmetry reduction benefits accruing to issuers and market participants.

Asset location in tax-deferred and conventional savings accounts

This paper derives optimal asset allocations (which assets to hold) and asset locations (in which accounts to hold them) for a risk-averse investor saving for retirement. The investor can hold taxable corporate bonds, tax-exempt municipal bonds, and stocks either in a tax-deferred or a conventional taxable savings account. Taxable bonds have a preferred location in the tax-deferred account and tax-exempt bonds have a preferred location in the taxable account for investors in sufficiently high tax brackets. Tax-efficient stock portfolios (e.g. passively-managed mutual funds) should be held in the taxable account and tax-inefficient stock portfolios (e.g. actively-managed mutual funds) should be held in the tax-deferred account. We show that locating assets optimally can significantly improve the risk-adjusted performance of retirement saving.

A fiscal federalism approach to infrastructure policy

This paper presents a fiscal federalism perspective on infrastructure policy. It begins by looking at the theory of fiscal federalism and then turns to the actual division of the responsibility for providing public capital in the United States. The paper then argues that it is difficult to square theory and actual practice: a good case can be made that national infrastructure policy is inconsistent with the principles of fiscal federalism in a number of important respects. The final sections of the paper look at two specific issues in federalism, the tax exempt municipal bond market and interjurisdictional competition.

The Long-Run Linkage Between Yields on Treasury and Municipal Bonds and the 1986 Tax Act

The Tax Act of 1986 changed the tax treatment of tax-exempt municipal bonds for banks. Since banks were the dominant participant in the municipal bond market until 1986, some believe that this resulted in the breakdown of the long-run equilibrium relationship between municipal and U.S. treasury securities of equal maturity. We present evidence that there was a significant break in the relationship muncipal and Treasury bonds around the time of the Tax Act but that break is in the mean of the equilibrium relationship and does not change the slope parameter that links the two interest rates in the long-run. Once this break is accounted for using a dummy variable the relationship between municipal and Treasury yields remains intact.

Taxable Municipal Bonds: State and Local Governments Confront the Tax-Exempt Limitation Movement

The 1980s brought dramatic changes for state and local finance. The decade began in the midst of a citizen-led tax revolt, followed by a precipitous decline in federal aid. It ended with a less visible yet no less dramatic change taking shape in the source of long-term debt used by these governments to finance capital improvements. Two recent watershed events-passage of the Tax Reform Act of 1986 and the U.S. Supreme Court's 1988 decision in South Carolina v. Baker-have placed a damper on state and local governments' mainstay in debt financing, the taxexempt municipal bond. As with the tax limitation movement, the move to limit tax-exempt securities has forced these governments to seek alternative sources of capital, including issuing taxable municipal bonds. This article examines the political events giving rise to the tax-exempt limitation movement, the investment market's response to taxable municipal bonds, and the financial implications for issuers of these new securities.

An Analysis of the Determinants of the Yield on Individual Municipal Securities

This study presents the results of a comprehensive regression analysis of the determinants of tax-exempt municipal bond yields.

Expected Inflation and the Real Rates of Interest on Taxable and Tax-Exempt Bonds

This paper analyzes the impact of inflation on rates of return on taxable corporate bonds and tax-exempt municipal bonds. The paper considers a differential tax system, where the tax rate depen ds on both the identity of the investor and the source of income. It also consid ers the possibility that inflation may induce investors to switch from holding one asset to holding another. It is demonstrated that while inflation should increase the (pre-personal tax) real rate of interest on taxable bonds, it should reduce the real rate of interest on tax-exempt bonds. Copyright 1987 by Ohio State University Press.

Taxes, Capital Structure, and Bondholder Clienteles

Despite much recent progress, financial theory has yet to explain the connection, if any, between the U.S. tax code and many observed characteristics of corporate bonds.' Empirically, why is there no single tax rate equating yields on corporate bonds with yields on tax-exempt municipal bonds of apparently identical risks and maturities?2 Specifically, why does the spread in yields between corporate and municipal bonds divided by the yield on corporates, a conventional measure of the marginal tax rate on corporates, decrease with increasing risk and maturity? More generally, why are different types of bonds evidently held by clienteles of investors in Tax clienteles for corporate bonds are identified in a competitive financial equilibrium. Under an asymmetric corporate income tax with interest preceding principal, state-contingent bonds with higher coupon yields are issued by firms with higher pretax cash inflows per dollar of nondebt tax shield, purchased by investors in lower tax brackets, and implicitly priced at lower marginal tax rates. On these bonds all investors earn tax-induced 'surpluses. By contrast, all other bonds have implicit tax rates typically equal to the corporate rate and yield for many investors no tax-induced surpluses. * We gratefully acknowledge the helpful comments of George Constantinides, Kose John, Merton Miller, Jim Scott, Marti Subrahmanyam, and participants in seminars at Baruch, Chicago, Columbia, Houston, Michigan, NYU, Rutgers, USC, Washington, Wharton, the American Finance Association, the Western Finance Association, and the Johnson Symposium on Taxes and Finance at Wisconsin. George Constantinides was especially helpful. 1. The most notable contribution is Miller (1977). Other recent papers include Chen and Kim (1979); Kim, Lewellen, and McConnell (1979); DeAngelo and Masulis (1980a, 1980b); Taggart (1980); Kim (1982); Auerbach and King (1983); and Talmor, Haugen, and Bornea (1985). Black (1971) anticipates an equilibrium with clienteles. 2. Schaefer (1982a) identifies tax-induced clienteles of bondholders in the British gilt market. Van Horne (1982) reports that implicit tax rates vary over time as the supply of discount bonds changes. Additional evidence is cited in Trczinka (1982).

On the Existence of an Optimal Capital Structure: Theory and Evidence

ONE OF THE MOST contentious issues in the theory of finance during the past quarter century has been the theory of capital structure. The geneses of this controversy were the seminal contributions by Modigliani and Miller [18, 19]. The general academic view by the mid-1970s, although not a consensus, was that the optimal capital structure involves balancing the tax advantage of debt against the present value of bankruptcy costs. No sooner did this general view become prevalent in the profession than Miller [16] presented a new challenge by showing that under certain conditions the tax advantage of debt financing at the firm level is exactly offset by the tax disadvantage of debt at the personal level. Since then there has developed a burgeoning theoretical literature attempting to reconcile Miller's model with the balancing theory of optimal capital structure [e.g., DeAngelo and Masulis [5], Kim [12], and Modigliani [17]. The general result of this work is that if there are significant "leverage-related" costs, such as bankruptcy costs, agency costs of debt, and loss of non-debt tax shields, and if the income from equity is untaxed, then the marginal bondholder's tax rate will be less than the corporate rate and there will be a positive net tax advantage to corporate debt financing. The firm's optimal capital structure will involve the trade off between the tax advantage of debt and various leverage-related costs. The upshot of these extensions of Miller's model is the recognition that the existence of an optimal capital structure is essentially an empirical issue as to whether or not the various leverage-related costs are economically significant enough to influence the costs of corporate borrowing. The Miller model and its theoretical extensions have inspired several timeseries studies which provide evidence on the existence of leverage-related costs. Trczinka [28] reports that from examining differences in average yields between taxable corporate bonds and tax-exempt municipal bonds, one cannot reject the Miller hypothesis that the marginal bondholder's tax rate is not different from the corporate tax rate. However, Trczinka is careful to point out that this finding does not necessarily imply that there is no tax advantage of corporate debt if the personal tax rate on equity is positive. Indeed, Buser and Hess [1], using a longer time series of data and more sophisticated econometric techniques, estimate that the average effective personal tax rate on equity is statistically positive and is not of a trivial magnitude. More importantly, they document evidence that is consistent with the existence of significant leverage-related costs in the economy.

Effect of extremes of temperature and humidity on the goblet cell count in the rat airway epithelium.

Effective duration, calculated by parallel shifts of the yield curve, is the standard measure of portfolio-based interest rate risk. Key rate durations, obtained by shifting individual key rates, describe how the risk is distributed along the term structure. Ordinarily the sum of the key rate durations equals the effective duration. However, in the case of tax-exempt municipal bonds the sum and the effective duration may differ. The reason is that the prices of discount munis are tax-affected, and the applicable tax rate depends on the size of the discount. The authors’ result has ramifications for the hedging of muni portfolios, and for the measurement of interest rate risk under the recently introduced SEC N-Port regulation. <b>TOPICS:</b>Project finance, statistical methods, credit risk management <b>Key Findings</b> • The tax effect on the price of a discount muni depends on the size of the discount (applicable tax rate around 20% if <i>de minimis</i>, 40% if not). • Because bumping individual key rates has smaller effects on price than shifting the entire yield curve, the applicable tax rates may differ. • Consequently key rate durations for munis may not add up to effective duration, creating challenges for portfolio hedging and SEC risk reporting.

State Pension Fund Investment Policy

W ITH THE EMERGENCE of pension funds as a major financial intermediary with assets of $159 billion in 1965, economists and investment analysts have devoted much attention in recent years to the performance and impact on capital markets of these funds.' Some of this concern has focused on the investment policies and practices of the funds, and in particular, state and local government pension funds with portfolios approaching $34 billion have been a favorite target for criticism, since they generally have achieved a lower rate of return on investment than their closest counterparts, the private pension funds.2 This inferior performance, it is held, is due to the restraints imposed on portfolio management by law and tradition, thus it has been widely accepted that the asset mix of the public plans should more closely resembile the private funds in order to optimize yields on investment.' Inferentially, it follows that the rate of contributions can then be decreased, given some fixed schedule of pension benefits. More specifically, the major complaints leveled against the state and municipal funds have been that common stocks and mortgages have been far too small a proportion of total assets, and that the placement of taxexempt state and municipal bonds, with a lower yield than quality corporate bonds and other securities is indefensible, since the fund itself is tax free. Over the years, there seems to have been some response to these criticisms, for equities and mortgages have risen to modest proportions, although common stock ownership is still far below the levels found in private pension funds. The response to the stricture against tax-exempts, however, has been most vigorousstate pension funds alone have reduced their holdings from 17.5% to 4.3% of aggregate assets in the last decade.4 What are the possible consequences of sales of tax-exempts by State Pension Funds?

Effect of Taxation on Valuation and Production Engineering

Introduction Taxes are important in the evaluation of any investment. For example, the market price of a tax exempt municipal bond will usually be higher than the market price of a fully taxable industrial bond of equivalent interest rate and security. Similarly, the buyer of a business will consider the impact of taxes in determining its potential yield and payout. The timing and extent of capital improvement programs are also influenced by taxes. For example, the time of repayment and ability to repay purchase obligations will be materially influenced by the ability to deduct the cost of improvements through depreciation or depletion charges. The oil and gas industry is affected by certain special rules of taxation which tend to make tax considerations of paramount importance to the industry. Some of these specialized concepts will be discussed and their effect upon specific transactions will be examined. Property Unit If the land department of an oil company secures four 160-acre leases from four different landowners, thereby securing a 640-acre tract, the operating departments of the company would likely regard such a tract as a single property for most purposes. However, under income tax rules, the company is regarded as having four properties, even though 640-acre spacing might be required, absent an election to aggregate, which will be discussed presently. Property is defined by the Internal Revenue Code as "each separate interest owned by the taxpayer in each mineral deposit in each separate tract or parcel of land". This definition places emphasis on the concept of separateness whether it arises by reason of the nature of the interest owned by the taxpayer, the various deposits under the tract of land, or the number of tracts or parcels into which it may be carved. The types of interest which may be regarded as separate would refer to the kind of interest owned by the taxpayers such as a fee simple, working interest, royalty, or over-riding royalty, etc. Regardless of how or when acquired, each such interest would be regarded as a separate property for depletion purposes, except in certain very special circumstances. If several mineral deposits are under a single tract or parcel of land, each deposit is regarded as a separate property.