Saturday, April 28, 2007
The muni puzzle refers to the empirical fact that relative to taxable bond yields, long–term tax–exempt yields are significantly higher than predicted by theory, while short–term yields conform well to theory. The systematic risk hypothesis is a candidate to explain the muni puzzle. I find that risk characteristics of government and municipal bond portfolio returns are very similar across the term structure. From this evidence, I conclude that systematic risk is unlikely to explain the muni puzzle. I also illustrate that a tax adjustment to duration is important when comparing the expected volatility of bonds with different tax status.