October, 2007

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

Key materials
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Our Findings

  • While standard economic theory suggests that the untaxed yields on municipal bonds should roughly equal the after-tax yields on Treasury bonds, actual yield data show that the untaxed yields on municipal bonds are much higher. Scholars refer to this phenomenon as the municipal bond puzzle.
  • Increases in purchases of U.S. Treasury bonds by foreign investors are associated with changes in the relationship between Treasury and municipal bond yields, and are thus a factor that contributes to the municipal bond puzzle.
  • In conjunction with prior studies, we find that changes in the relationship between municipal and Treasury bond yields correspond to changes in corporate income tax rates, personal income tax rates, the liquidity of municipal bonds relative to Treasury bonds, and the supply of municipal and Treasury bonds issued by the federal and municipal governments.

By the Numbers

  • For municipal and Treasury bond issues with terms to maturity of 1, 2, 5, 10, 15, 20, and 30 years, as foreign purchases of U.S. Treasury bonds increase by one percent, municipal yields increase relative to Treasury yields by a factor of 0.68.


  • While federal policymakers originally exempted municipal bond yields from income taxation to encourage increased investment in municipal bonds, this action incidentally caused an increase in foreign investment in Treasury bonds.
  • As foreign investors continue to increase their purchases of U.S. Treasury bonds, this will drive down the yields on these bonds so that domestic investors will have an increasing incentive to invest in comparatively higher-yield municipal bonds.
  • If foreign investors shift their investments away from U.S. Treasury bonds by investing in other securities (i.e. private equities) or foreign government bonds, this will make municipal bonds an increasingly less attractive investment to domestic investors as their yields decline relative to Treasury bonds.