The Muni Bond Spread: Credit, Liquidity, and Tax

Municipal (muni) bonds are risky and trade in illiquid markets, and both effects serve to raise muni yields relative to Treasuries. On the other hand, the tax exemption of muni bonds tends to lower their yields. We decompose the muni yield spread into credit, liquidity, and tax components. Before 2008, muni yields are reliably lower than Treasuries. After the 2008 financial crisis, the muni-Treasury spread flips sign to, on average, 0.87%, comprising credit, liquidity, and tax components of 0.57%, 2.14%, and -1.84%, respectively. Muni credit and liquidity components exhibit strong covariation with credit and liquidity factors prevailing in other asset classes.