Default risk cannot explain the Muni puzzle: evidence from municipal bonds that are secured by U.S. treasury obligations

Fama (1977) and Miller (1977) predict that one minus the corporatetax rate will equate after tax yields from comparable taxableand tax-exempt bonds. Empirical evidence shows that long-termtax-exempt yields are higher than theory predicts. Two popularexplanations for this empirical puzzle are that, relative totaxable bonds, municipal bonds bear more default risk and includecostly call options. I study U.S. government secured municipalbond yields which are effectively default-free and noncallable.These municipal yields display the same tendency to be too high.I conclude that differential default risk and call options donot explain the municipal bond puzzle.