Implications of Foreign Investment Patterns for Federal, State, and Local Bond Financing

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1 Working Paper Implications of Foreign Investment Patterns for Federal, State, and Local Bond Financing PATRICK MANCHESTER AND ANTONY DAVIES The ideas presented in is research are e auor's and do not represent official posions of e Mercatus Center at George Mason Universy.

2 What is e Municipal Bond Puzzle? First identified by scholars in e 1970s, e municipal bond puzzle refers to e unusual relationship between e yields of U.S. Treasury and municipal bonds at deviates from standard economic eory. One of e key differences between Treasury and municipal bonds is at while interest income from Treasury bonds is subject to taxation, interest income from municipal bonds is not. Economic eory suggests at e difference in tax treatment will result in a predictable difference in yields for e two types of bonds. Economists argue at buyers and sellers will bargain until e after-tax yield on Treasury bonds is equal to e untaxed yield on municipal bonds. The municipal bond puzzle emerges because is predicted relationship does not hold empirically. Actual bond yield data suggest at e untaxed yields on municipal bonds are greater an e after-tax yields on Treasury bonds (see Figure 1). Figure 1. Treasury and Municipal Bond Yields Yields 4.300% 4.100% 3.900% 3.700% 3.500% 3.300% 3.100% 2.900% 2.700% 2.500% 1-Year 2-Year 3-Year 4-Year 5-Year 7-Year 10-Year 15-Year 20-Year 25-Year 30-Year Term to Matury Untaxed AAA Municipal Yields After-Tax Treasury Yields Source: Bloomberg Financial (November 2, 2006) Figure 1 suggests at, ignoring e difference in risk, bond investors should invest solely in municipal bonds because eir yields are higher an e after-tax yield on Treasury bonds. 1

3 Why is e Puzzle Important for Policy Decisions? The municipal bond puzzle is an important concept for state and local policymakers because of eir use of bond issues to finance government activies. As we will demonstrate later in is paper, factors at alter e relationship between Treasury and municipal bond yields will have an impact on e abily of municipal governments to attract investors to purchase eir bonds. Similarly, changes in e relationship between municipal and Treasury yields have implications for federal policymakers. As we will demonstrate, changes in e relative yields of Treasury and municipal bonds are likely to affect bo e volume and type of investors interested in purchasing U.S. Treasury bonds. Thus, changes in any of e factors generating e municipal bond puzzle could alter e cost to e federal government of financing s activies rough bond issues as well as alter e composion of e parties to which e federal government is indebted. Possible Explanations for e Municipal Bond Puzzle? Economists have proposed several explanations for why e municipal bond puzzle occurs. Differences in default risk. Because municipal bonds carry a higher risk of default an Treasury bonds, investors would naturally demand a higher rate of return on municipal bonds (Liu et al., 2003). However, scholars are not in complete agreement on wheer is effect can fully explain e puzzle. Studies at have examined e relationship between e yields on Treasury bonds and very low risk municipal bonds have found at e municipal bond puzzle persists. These studies conclude at default risk cannot explain why e puzzle occurs (Chalmers, 1998). 2

4 Differences in liquidy. Because e municipal bond market is less liquid an e Treasury bond market, investors would naturally demand a higher return on municipal bonds (Wang et al., 2005). Expectations of higher taxes. Some researchers have suggested at investors may anticipate a change in e tax treatment of municipal bond yields (Poterba, 1986). Portfolio structure. Oers have suggested at e way investors structure eir portfolios may reduce eir incentive to invest in tax-exempt bonds over taxable bonds (Green, 1993). Composion of investors. Finally, some economists argue at changes in tax law have changed e composion of investors in municipal bonds. Previously dominated by commercial banks, e market for municipal bonds is increasingly comprised of oer types of investors in light of tax reforms. Some scholars argue at municipal yields have increased relative to after-tax Treasury yields to induce individual investors to purchase municipal bonds. Thus e puzzle occurs because untaxed municipal bond yields remain higher an after-tax Treasury yields to fill e gap previously occupied by commercial bank investors (Hein et al., 1995). An Alternate Explanation for e Puzzle In is paper, we hypoesize at a factor contributing to e municipal bond puzzle is e increased volume of foreign investment in U.S. Treasury bonds in recent years. Because foreign investors are not subject to U.S. income tax law, e investors will be more likely to purchase Treasury bonds because e bonds carry higher pre-tax yields an municipal bonds. Increases in eir purchases of Treasury bonds will drive Treasury yields lower so at e aftertax Treasury yields become lower an e untaxed yields on municipal bonds. 3

5 Using statistical modeling, we find at, holding all else equal, increases in foreign purchases of U.S. Treasury bonds have corresponded to decreases in e yields on Treasury bonds so at e gap between e yields on untaxed municipal bonds and e after-tax yields on Treasury bonds has widened. * We conclude at e municipal bond puzzle is due, at least in part, to increased purchases of U.S. Treasury bonds by foreign investors. Implications for Federal, State, and Local Policymakers Our conclusion at foreign purchases in U.S. Treasury bonds form one of e main drivers of e municipal bond puzzle has major implications for policymakers on all levels of government. First, our results suggest at by allowing municipal bond yields to be tax free, e federal government has encouraged foreign investment in Treasury bonds. By designating municipal bond yields as free from federal income taxation, federal lawmakers originally intended to make easier for state and local governments to finance eir activies rough bond issues. However, was actually an unanticipated consequence of is tax provision at has facilated bond financing at e state and local level. Namely, because e federal government has exempted municipal bond yields from taxation, has induced increased foreign investment in Treasury bonds, and provided addional incentive for domestic investors to purchase municipal bonds. Our results suggest at continued foreign investment in Treasury bonds will continue to drive down e yields on ese bonds relative to municipal bonds. As a result, e after-tax yield on Treasury bonds will decrease to become less an e untaxed yield on municipal bonds. Thus, is will give domestic investors greater incentive to increase eir purchases of municipal bonds, while giving foreign investors incentive to increase eir purchases of Treasury bonds. Our results suggest at e market for government-issued bonds is likely to become segmented * See Appendix 4

6 as a result of increased foreign purchases of federal bond issues. From e perspective of local policymakers, ese results could be very posive in at as long as foreign investors continue to show more interest in Treasury bonds, will become easier for municipal governments to finance eir activies rough bond issues because municipal bonds will become a more attractive investment for domestic investors. It also means, however, at e federal government will find self increasingly indebted to foreign investors as domestic investors shift eir investments out of comparatively lower-yielding Treasury bonds. This segmentation effect is migated if foreign investors show greater interest in oer investment vehicles like private equies. The decreased demand for Treasuries would drive up e yields so at eir after-tax yields would become comparatively much more attractive to domestic investors. Thus, e segmentation of foreign investors in Treasury bonds and domestic investors in municipal bonds would likely blur. This conclusion has implications particularly for local and state policymakers in at suggests at e global bond market is as important for federal policymakers as is for state and local policymakers. Paying attention to foreign investment strategies, such as e recent Chinese purchase of a stake in Blackstone, can help local-level policymakers determine market climates in which bond issuance is a good strategy for raising capal. Our conclusions suggest at increases in equy investment by large foreign investors in e Uned States are likely to have an impact on municipal governments to e extent at ey can lead to a decrease in e volume of domestic investors willing to purchase municipal bonds. The ird conclusion at we can draw from our research is at a major future sell off of U.S. Treasury bonds will have an impact not only on e federal government s finances, but e finances of state and local governments as well. If, as some scholars and analysts have predicted, 5

7 large scale investors in U.S. Treasury bonds start moving eir assets toward oer investments, such as Euro-denominated bond issues, is will likely drive up e yields on U.S. Treasury bonds to e point where eir after-tax returns may be greater an untaxed municipal yields. Thus a major shift in investment away from U.S. Treasury bonds by large scale foreign investors could have far-reaching effects in e Uned States in at could make more difficult for municipal governments to finance eir activies rough municipal bond issues since domestic investors would be more likely to shift eir assets into Treasury bonds. 6

8 Appendix In order to determine e factors at likely affect e relationship between Treasury and municipal bond yields, we estimated e following econometric model: M M M Y S Y = + C + P + L + + F + + Y S Y i, t 1 α β β β β β β ε T 1 t 2 t 3 4 T 5 6 T i, t 1 Municipal bond yield of e term to matury at time M Y i t T Y Treasury bond yield of e i term to matury at time t C P t Highest marginal corporate income tax rate at time t Average marginal personal income tax rate at time t L Municipal bond liquidy measure for e i term to matury at time t S Supply of municipal bonds of e i M T S Supply of Treasury bonds of e i term to matury at time t term to matury at time t F Grow rate, from time t 1 to t, in foreign purchases of Treasury bonds of e i term to matury The data span e period from e second quarter of 1992 to e four quarter of 2006 and includes 1-year, 2-year, 5-year, 10-year, 15-year, 20-year, and 30-year maturies. We estimate is model via two-stage least squares using e above regressors lagged 1, 2, and 3 periods as instruments for e lagged yield ratio. The results of our estimation appear in Table 1: 7

9 Table 1. Estimated Econometric Model Coefficient Estimate Standard Error αˆ (0.216)* ˆβ (0.006)* 1 ˆβ (0.002)** 2 ˆβ ( )** 3 ˆβ (0.150)** 4 ˆβ (0.007)** 5 ˆβ (0.042)** 6 2 R Durbin-Watson **Significant at 1% level, *Significant at 5% level Based on e fact at e foreign investment variable ( ˆβ 5 ) is posive and significant at e 1-percent level, we conclude at increases in e grow rate of foreign purchases of U.S. Treasury bonds correspond to increases in e yield ratio. We hypoesize at ese increases in e yield ratio are due to e fact at increased foreign investment in U.S. Treasury bonds causes e yields on Treasury bonds to increase so at eir after-tax yields decline in relation to e untaxed yields of municipal bonds. 8

10 References Chalmers, J.R Default Risk Cannot Explain e Muni Puzzle: Evidence from Municipal Bonds at are Secured by U.S. Treasury Obligations. The Review of Financial Studies 11 (2): Green, R.C A Simple Model of e Tax-Exempt and Taxable Yield Curves. The Review of Financial Studies 6 (2): Hein, S.E., Koch, T.W., and MacDonald, S.S The Changing Role of Commercial Banks in e Municipal Securies Market. Journal of Money 27 (3): Liu, S., Wang, J., and Wu, C Effects of Cred Qualy on Tax-Exempt and Taxable Yields. Journal of Fixed Income 13 (2): Poterba, J.M Explaining e Yield Spread between Taxable and Tax-Exempt Bonds, in H. Rosen (ed.). Studies in State and Local Public Finance, Universy of Chicago Press: Chicago. Wang, J., Wu, C., and Zhang, F Liquidy, Default, Taxes and Yields on Municipal Bonds. FEDS Working Paper No