The term structure of municipal bond yields, local economic conditions, and local stock returns∗

This study shows that the municipal yield curve is informative about local economic outcomes. Controlling for Treasury yields, a flatter municipal yield curve not only predicts deteriorating local economic conditions, such as higher unemployment rates and more macroeconomic uncertainty, but also signals greater risk for locally headquartered firms. An investment strategy that exploits this fact by buying (selling) the firms located in states where municipal yield curve is relatively flat (steep) earns an excess return that exceeds 5% per annum. These novel empirical results indicate that the municipal debt market provides valuable information about the trajectories and risks of local economies. ∗Fotis Grigoris is at the Kenan-Flagler Business School at the University of North Carolina at Chapel Hill, Chapel Hill, NC 27599 (e-mail: fotis_grigoris@kenan-flagler.unc.edu). I am grateful to my dissertation committee, Ric Colacito, Eric Ghysels (co-chair), Chris Lundblad (co-chair), and Gill Segal, for their continuous support, mentoring, and encouragement. This paper has also benefited from comments from Yasser Boualam, Stephen Brown, Oleg Chuprinin (discussant), Jennifer Conrad, Jesse Davis, Andra Ghent, Andrei Gonçalves, Yunzhi Hu, Nina Karnaukh (discussant), Cami Kuhnen, Adam Reed, Jacob Sagi, Donghwa Shin, Andreas Stathopoulos, and seminar participants at the 32nd Australian Finance and Banking Conference and the University of North Carolina at Chapel Hill. All errors are my own. First Draft: November 10, 2018. Municipal bonds are a key source of funding for state and local governments, and allow these entities to finance their budgets by selling debts backed by their expected future cash flows. While existing studies show that the shape of the Treasury yield curve predicts aggregate economic outcomes (e.g., Harvey (1988); Estrella and Hardouvelis (1991); Ang, Piazzesi and Wei (2006b)), little is known about whether municipal yield curves convey valuable information about local (i.e., state-level) economic outcomes. In this study I document empirically that the long-term slope of the term structure of municipal spreads (municipal yields minus Treasury yields) is informative about both local macroeconomic conditions and local asset prices. Specifically, I define the long-term slope of the term structure of municipal spreads (referred to as the “long-term slope of the municipal spread” hereafter) as the difference between 20 year and 5 year municipal yields in excess of Treasury yields, and show that in states where this slope is flatter: (i) local economic activity, as measured by variables such as the unemployment rate, deteriorates and local economic uncertainty, as measured by the conditional volatility of economic activity, rises; and (ii) locally headquartered firms earn stock returns that are 0.43% per month higher and have higher market betas. I reconcile facts (i) and (ii) jointly by documenting that higher local uncertainty predicts higher return volatilities for local firms. My focus on the information content of the long-term slope of the municipal spread is based on four observations. First, since the cash flows underlying municipal bonds are influenced by future economic activity, municipal yields should embed investors’ expectations of future outcomes. Second, municipal spreads largely reflect default risk (Schwert, 2017), a predictor of economic activity. Third, as the slope of the Treasury yield curve predicts aggregate economic activity, a similar result may carry over to the municipal yield curve and local economic activity. Finally, unlike trading in Treasuries, trading in municipal bonds is concentrated among longterm securities (those with 10 or more years to maturity). Together, these observations suggest that the long-term slope of the municipal spread is likely to predict local economic outcomes. I measure the long-term slope of the municipal spread by estimating a term structure model drawn from Diebold, Li and Yue (2008). The model first distills each state’s municipal yield curve into three factors, one of which is closely related to the long-term slope of the yield curve. The model then accounts for the fact that municipal yields in each state are driven by both national and local economic forces. This is done by decomposing each yield factor into two