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


  • We thank Bill Christie (Editor), Cheol Eun, Andrea Gamba, Narayanan Jayaraman, Francis Longstaff, Vikram Nanda, an anonymous referee, and seminar participants at the American University, the Georgia Institute of Technology, and the 2009 EFMA Conference in Milano, Italy for helpful comments. Qinghai Wang acknowledges the financial support of the Mills B. Lane Term Professorship at the Georgia Institute of Technology.


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 demonstrate that market segmentation imposes significant costs on both issuers and investors in the form of higher yields and higher costs of financial intermediation. Our results provide insight into some well-documented artifacts of the municipal bond market, such as high yields and the popularity of insurance.