Municipal-Treasury Spreads and Local Stock Returns

Fotis Grigoris

♦ This study shows that municipal bond yields are informative about the risk exposures and expected returns of local firms. An investment strategy that buys (sells) firms located in states where the municipal-Treasury spread is high (low) earns an average return of 0.36% per month. This return differential cannot be explained by limits-to-arbitrage, industry agglomeration, or a host of prominent asset-pricing characteristics. Rather, the municipal-Treasury spread predicts stock returns because it serves as an observable proxy of local fundamentals, such as labor productivity. Firms’ risk exposures are higher and state-level fundamentals are weaker in states with higher municipal-Treasury spreads.

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