Tax-Driven Illiquidity, Portfolio Constraints, and Municipal Borrowing Costs
Publication Date
9-14-2026
Abstract
We study how the market discount rule in the U.S. tax code affects investor behavior and municipal borrowing costs. When a tax-exempt municipal bond is purchased below a bond-specific de minimis threshold, its pull-to-par appreciation is taxed as ordinary income, rendering such bonds unattractive to tax-sensitive municipal bond funds. As their portfolio holdings approach the threshold—due to rising interest rates or credit spreads—muni funds anticipate illiquidity and hoard cash, reducing their willingness to deploy capital in new bond offerings. We show that when existing investors of a municipal issuer are collectively closer to the threshold, they participate less in the issuer's new offerings, raising the offering yield and reducing financing capacity—even for issuers whose bonds are not themselves subject to the tax penalty.
Document Type
Article
Keywords
mutual funds, tax clientele, portfolio constraints, liquidity management, cost of debt, capital supply, municipal bonds
Disciplines
Finance
Language
English
