Solving the Swedish Muni Puzzle - Piece By Piece

Abstract: This paper examines whether liquidity premiums can explain the Swedish muni puzzle. The Swedish institutional climate presents a unique setting where default risk and taxes are equivalent in the context of municipal and treasury bonds. Despite these similarities, we show that their yields still differ substantially from one another after adjusting for coupons, peaking at as high as 178 basis points during the depths of the European sovereign debt crisis. Operationalizing liquidity as proportional bid-ask spreads, we construct measures of contemporaneous and future liquidity and examine their explanatory power in the Swedish muni puzzle. Adjusting for days to maturity and orthogonalizing contemporaneous liquidity relative to future liquidity, we show that differences in contemporaneous liquidity between municipal and treasury bonds can help explain the muni puzzle. The results are statistically significant on the 1 percent level using two different types of panel correlation methods. We find a significant constant of approximately 20 basis points which cannot be explained by any of the mainstream explanatory variables typical to the muni puzzle.