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Why are municipal bonds issued at a premium?
Coauthor(s): Mattia Landoni
After-tax pricing of tax-exempt bonds suggests an explanation for two previously unexplained stylized facts in the 4-trillion-dollar municipal bond market: the fact that many bonds are issued at a premium, and the fact that coupons are “sticky”, i.e. they stay high around 5% even when yields fall. The underlying mechanism is simple: it is the coupon, not the yield, that is tax-exempt; a high coupon rate is efficient, because it ensures that the bond stays fully tax exempt even if later it trades at a higher yield. The same mechanism also predicts a third, previously undocumented, stylized fact: issue prices of noncallable tax-exempt bonds are increasing in time to maturity. I show that this “term structure of issue prices” exists, using a collection of 200,000 unique securities held by insurance companies.
Mattia Landoni "Why are municipal bonds issued at a premium?." , Columbia Business School, (2013).