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«Abstract We study the implications of market segmentation in a domestic setting, the US municipal bond market. A (state-level) segmentation of this ...»

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Market Segmentation and the Cost of Capital in a Domestic Market: Evidence

from Municipal Bonds *

Christo A. Pirinsky

Qinghai Wang

Abstract

We study the implications of market segmentation in a domestic setting, the US municipal bond

market. A (state-level) segmentation of this market emerges from asymmetric tax-exemption -municipal bond investors are exempt from state and local taxes on bonds issued by their own state

but not on bonds issued by other states. We find that market segmentation limits the risk-sharing opportunities for investors, creates impediments to arbitrage, and increases the need for financial intermediation. Our results provide a unified explanation for a set of well-documented artifacts of the municipal bond market, such as its high yields, high transaction costs, and popularity of insurance. Our overall conclusion is that segmentation imposes significant costs in capital markets and these costs could materialize through different venues, only one of which is yields.

December 2009 * We thank Cheol Eun, Andrea Gamba, Narayanan Jayaraman, Vikram Nanda, and seminar participants at Georgia Tech and the 2009 EFMA conference in Milano, Italy for helpful comments. Christo A. Pirinsky, Department of Finance, George Washington University, 2201 G Street, Funger Hall 501, Washington, DC 20052, pirinsky@gwu.edu, (202) 994-2377. Qinghai Wang, College of Management, Georgia Institute of Technology, 800 West Peachtree Street NW, Atlanta, GA 30308, qinghai.wang@mgt.gatech.edu, (404) 385-3266 Market Segmentation and the Cost of Capital in a Domestic Market: Evidence from Municipal Bonds Abstract We study the implications of market segmentation in a domestic setting, the US municipal bond market. A (state-level) segmentation of this market emerges from asymmetric tax-exemption -municipal bond investors are exempt from state and local taxes on bonds issued by their own state but not on bonds issued by other states. We find that market segmentation limits the risk-sharing opportunities for investors, creates impediments to arbitrage, and increases the need for financial intermediation. Our results provide a unified explanation for a set of well-documented artifacts of the municipal bond market, such as its high yields, high transaction costs, and popularity of insurance. Our overall conclusion is that segmentation imposes significant costs in capital markets and these costs could materialize through different venues, only one of which is yields.

JEL classification: G14; G20 Keywords: Cost of capital, market segmentation, municipal bonds Economic theory predicts that, by promoting better risk-sharing, integrated capital markets can lower the cost of capital and improve the allocative efficiency in capital markets. However, evaluating the real effects of capital market integration has been a challenging task, given that most markets exhibit substantial differences in their legal, institutional, and cultural environment, which creates difficulties in quantifying both the degree of integration and its impact. While some empirical studies have shown that market integration decreases the cost of capital, the documented effects are lower than theory predicts and many have even contended that the benefits of integration are too small to offset some of its harmful side effects, such as increased speculation and likelihood for financial crises.1 In this paper, we study the implications of market segmentation within a domestic setting, the U.S. municipal bond market. The income from most municipal bonds is exempt from state and local taxes for in-state investors but not for out-of state investors. This asymmetric tax-exemption creates an exogenous friction that segments the municipal bond market, thus offering a unique venue to evaluate the effects of market segmentation on issuers and investors. By restricting our study to the U.S. domestic market, we can easily control for differences in institutional settings that are present in international markets.

Studying the municipal bond market has several important advantages for understanding the effects of segmentation in financial markets. First, the rich data on municipal bonds allows us to examine the impact of market segmentation on a wide range of costs, such as floatation costs and other fees to financial intermediaries, which are generally not reflected in yields and, as a result, have been overlooked in existing research. Second, the municipal bond market consists of a large number of issues with similar structure and risk characteristics, which enables us to design See Stulz (1999, 2005) for a review of the literature. Recent attempts to evaluate the impact of market integration on the cost of capital include Domowitz, Glen and Madhavan (1997), Foerster and Karolyi (1999), Bekaert and Harvey (2000), and Henry (2000), among others.

more powerful tests. Next, focusing on initial bond offerings (instead of realized returns to investors) allows for a more precise estimate of the actual cost of capital for the issuer. Lastly, our analysis could provide insight into a series of puzzling characteristics of the municipal bond market, namely its high yields (the Muni-puzzle), popularity of insurance, limits to arbitrage, and high transaction costs.

Our major results could be summarized as follows. First, we present strong evidence for state-level segmentation of the municipal bond market and show that this segmentation results in a significant valuation discount of municipal bonds. Second, we find that by limiting investor ability to diversify across state borders, tax-induced segmentation creates an incentive for insurance in the market, a cost borne largely by the issuer. Third, we show that segmented markets are characterized with higher costs of financial intermediation, as measured by underwriting fees and mutual fund expense ratios. Our overall conclusion is that segmentation imposes significant costs in capital market and these costs could take many forms, only one of which is yields.





We start our analysis by exploring theoretically how asymmetric tax exemption affects the demands and valuations in the municipal bond market based on a standard model of portfolio choice. In the model, tax-exemption of interest income creates an incentive for investors to invest in-state, while the risk of the bonds creates an incentive to invest out-of-state. We show that in equilibrium investors would be biased towards local bonds (from the state of the issuer) but they would always allocate funds to out-of-state bonds.

In this economy differential taxation adversely affects investors in two ways – directly, through the taxes paid on out-of-state interest income, and indirectly, by creating excessive exposure to local risks. This results in a discount of municipal bond prices relative to the prices of otherwise similar bonds that are not subject to differential taxation. The discount could be significant even for bonds with low level of risk if the average tax rate in the market is high and the state has relatively low demand for municipal bonds. The model provides testable hypotheses for the existence of segmentation in the municipal bond market and its impact.

Using a full sample of municipal bond new issues between 2001 and 2007, we provide empirical evidence for both state-level segmentation of the market and the associated costs of this segmentation. First, we find that the yields of municipal bonds are negatively related to local demand and positively related to local supply of bonds from the state of the issuer. Next, we examine the relationship between municipal bond yields and state-level demand and supply for the subsample of states with no income tax and for a control sample of taxable municipal bonds.

Consistent with the idea of stronger integration of these two markets, we confirm that municipal yields are less sensitive to local demand and supply in the two markets.

The sample of taxable municipal bonds provides a clean benchmark for estimating the costs of tax-induced segmentation in the market. Comparing the yields between taxable and nontaxable municipal bonds allows us to assess the impact of market segmentation on bond yields while effectively controlling for risk and various bond characteristics. We show that tax-exempt municipal bonds are consistently priced at higher (after-tax) yields than taxable municipal bonds – the average yield of tax-exempt bonds exceeds the average yield of similar taxable bonds by 62 basis points. As expected, the yield differential is stronger for bonds with lower credit rating and longer maturity.

Tax-induced market segmentation can also explain another puzzling characteristic of the municipal bond market – the popularity of municipal bond insurance.2 The tax-induced local bias of municipal bond investors results in an allocation which is sub-optimal from a risk-sharing perspective. Insurance companies, on the other hand, can effectively pool risks of municipal bonds across states and diversify large part of their regional risks, while allowing investors to maintain In recent years, nearly 50 percent of new municipal bond issues were insured (American Banker Incorporated, The Bond Buyer Yearbook, 2002).

the tax benefit. Consistent with this hypothesis, we show that the probability for insurance of a taxexempt municipal bond increases with the local supply of bonds in the market and the size of the offering. The probability for insurance of taxable municipal bonds, on the other hand, is not significantly related to the local supply of bonds in the state.

To investigate further the impact of market segmentation on the cost of capital for issuers and the expected returns for investors, we examine how market segmentation affects the costs of bond issuance and bond investment, respectively. In line with the idea that segmented capital markets exhibit higher issuing costs than integrated capital markets, we show that tax-exempt municipal bonds have higher underwriting spreads than similar taxable municipal bonds.

We next study the investment choices of municipal bond investors and the structure and fees of municipal bond mutual funds. Consistent with our model prediction that investors would always allocate part of their municipal bond portfolio to out-of-state bonds, we observe that investors direct substantial wealth towards national municipal bond mutual funds, thus foregoing their tax exemption at the state level. More importantly, single-state municipal bond mutual funds (funds that invest in municipal bonds from the same state and, as a result, offer state and local tax exemption benefits) charge higher fees than national funds and the level of the state fund fees is positively correlated with the level of the state income tax rate. The latter suggests that large part of the tax-benefits of municipal bonds for investors is actually offset by costs associated with investing in these bonds.

By studying a segmented market in a domestic setting, we show that segmentation imposes substantial costs in capital market. Segmentation affects the cost of capital not only directly, by increasing the yields of financial securities, but also indirectly by increasing the costs of financial intermediation in these markets associated with security issuance, insurance, and investor participation. We argue that the benefits of financial market integration documented in existing studies are very likely understated as a result of an incomplete measurement of the actual cost of capital in these studies.

Our results provide insights on some puzzling characteristics the municipal bond market, such as its high yields (the Muni-puzzle) and relatively low liquidity.3 The discount of municipal bonds relative to the prices of other similar bonds could be, at least partially, attributed to taxinduced regional segmentation of the municipal bond market. However, by restricting trading across state borders, market segmentation reduces not only the risk-sharing opportunities in the market but also its liquidity. Recent studies show that the municipal bond market has a surprisingly low liquidity given its size (see Green, Hollifield, and Schürhoff (2007) and Harris and Piwowar (2006)). We note that municipal bond illiquidity is an endogenous artifact of the market and it could be, to some extent, attributed to the regional segmentation of the market.

We also contribute to the analysis of tax-exemption policies. Most studies in this area focus on the tradeoff between lost revenues (from tax-exemption) and additional savings (due to lower yields), without explicitly consider the distortion effects of asymmetric tax-exemption associated with market segmentation (see Poterba and Verdugo (2008) for a review). Because market segmentation introduces significant deadweight loss to the market, both issuers and investors would be better off if the segmentation barriers are lifted. One possible policy solution is to eliminate the asymmetric tax treatment – by either exempting both in-state and out-of state municipal bonds from taxation or taxing both in-state and out-of state municipal bonds equally. In a widely followed Supreme Court ruling in 2008 regarding tax exemption of in-state bonds, the Supreme Court upheld the long-standing state tax exemptions for municipal bonds and ruled that Arak and Guentner (1983), Poterba (1986), and Green (1993), among many others, show that long-term municipal bond yields tend to be much higher than predicted by theory. Hempel (1972), Zimmerman (1977), and Fama (1977) argue that municipalities are more opaque than other issuers. In a recent article, Baber and Gore (2007) show that GAAP standards have become increasingly popular for municipalities and that GAAP requirements reduce municipal borrowing costs.

such exemption does not violate the Constitution’s commerce clause. Neither the court majority opinion nor briefs submitted by all fifty states and the Securities Industry and Financial Markets Association, however, have questioned the merits of such tax exemption policies and have only agreed that overturning the exemption would upset the market.4 The paper is organized as follows. Section I describes the municipal bond market and the associated tax policies; Section II presents a theoretical justification of the analysis; Section III describes the municipal bond data; Section IV presents evidence on the regional segmentation of the municipal bond market; while Section V explores the costs of market segmentation. We conclude in Section VI.



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