Academic journal article Financial Management

The Financial Performance of Low-Grade Municipal Bond Funds

Academic journal article Financial Management

The Financial Performance of Low-Grade Municipal Bond Funds

Article excerpt

Given the size of the U.S. tax-exempt bond market (which includes all the 50 states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, and Guam), there is surprising little research in this area. As of 1993, the Federal Reserve estimated the overall size of the municipal bond market at $1.2 trillion. This study broadens current research and provides a basis for future research on the relative performance of low-grade and high-grade municipal bond funds.

This study: (1) establishes the existence of the low-grade municipal bond asset class; (2) analyzes and extends the low- and high-grade corporate bond effect to municipal bonds; (3) analyzes the abnormality of the returns for low-grade municipal bonds; and (4) generally extends research on tax-exempt securities.

Over the study period, low-grade municipal bond funds return 0.63% per month with a 2.26% standard deviation, while high-grade municipal bond funds return 0.60% with a 2.40% standard deviation. Given standard quadratic utility, and assuming that risk and return are best described by historic standard deviation of returns and mean returns, low-grade municipal bond funds appear to dominate high-grade municipal bond funds. From January 1978 through September 1994, low-grade muni funds have had higher returns at a lower level of risk, than high-grade muni funds. Also, it is trivial to show that linear combinations of short-maturity and low-grade muni funds dominate intermediate and insured municipal bond funds. The apparent anomalous relation between low- and high-grade municipal bond funds is one of the issues addressed in this study. Although an equality of means t-test between the two asset-class return series shows no significant results. We ask if risk-adjusted low-grade municipal bond fund returns are greater than high-grade municipal bond fund returns.

This study examines the return experience of low- and high-grade muni funds over a long period (i.e., January 1978 through September 1994). The length of the study period allows me to compile evidence on the financial performance of low-grade munis, and to generally extend low-grade corporate bond analysis to the municipal market.

Although not statistically significant, low-grade municipal bond funds have generated a higher return at a lower standard deviation of return over the period examined. In a sense, the original Drexel hypothesis seems to hold for both municipal bond asset classes. (See Cornell and Green (1991) for a definition of the Drexel hypothesis.) In addition to low-grade municipal bonds possibly outperforming high-grade municipal bonds, there are several other seemingly anomalous low-grade corporate bond findings that I address in this study (Kihn, 1994). Specifically, they are: low-grade municipal bonds as an asset class may (1) show evidence of possessing a higher proportion of calls and/or weaker call protection than high-grade municipal bonds; and (2) demonstrate a return generation process which would suggest that changes in risk-free interest rates and/or the economy account for a significant amount of the relative return variation in the low-grade municipal market overall.

The paper is organized into five sections. Section I presents background on the data and provides summary statistics. Section II reviews the expectations/hypotheses developed from contingent claims analysis (CCA) risky-debt valuation models that are relevant to low-grade municipal bonds and their principal embedded options. Section III presents the low- and high-grade municipal bond declining-interest-rate regression results, recession regression results, and combination declining-interest-rate and recession regression results. Section IV examines how the January effect and the Tax Reform Act of 1986 may have affected low-grade municipal bond fund financial performance. Section V concludes.

I. Data and Summary Statistics

Part of the motivation behind my study is the observation by Skelton (1983) that comparably rated municipal and corporate bonds have similar risk profiles. …

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