Municipal Bond Demand Premiums and Bond Price Volatility: A Note

Authors

  • DUANE STOCK,

  • EDWARD L. SCHREMS

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    • Assistant and Associate Professors of Finance at the University of Oklahoma, respectively. This research was supported by a grant from the First City National Bank of Houston, Texas. The authors wish to thank Jeff Fitter for computational assistance and Tony Lis, Kathryn Jenson, Michael Donaghe, Shane Moriarity, Alexander Holmes, Charles Turner, R H Gilmer, David Mair, and Bryan Stanhouse for their comments.

ABSTRACT

The behavior of different components of municipal bond yields may have a significant impact upon bond price behavior. Specifically, demand premiums created by banks may stabilize bond yields in some maturity ranges but not in others; for example, short-term municipals may be stabilized but not long-term. This research implies that bank demand behavior may create demand premiums that stabilize prices of short-term municipal bonds relative to those of Treasury bonds of like maturity. While this implication is inconsistent with the residual theory of bank demand, it is consistent with the tax-shield theory attributed to Hendershott and Koch [3, 4].

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