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Abstract: 

This paper examines the dynamic adjustment process of the municipal bond risk structure. However, if there is asymmetry in the adjustment paths, standard cointegration tests may be misspecified and lead to misguided investment decisions. Using threshold cointegration and error correction techniques that allow the adjustment paths to be asymmetric, we find evidence of cointegration between lower- and higher-grade municipal bond yields. In addition, the responses of the municipal bond yields differ depending on whether the risk premium is widening or narrowing. An understanding of the asymmetry in the adjustment process would be beneficial to investors and portfolio managers in formulating appropriate yield spread strategies to capitalize on expected changes in the spread between municipal bond yields.

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Affiliations:  1: Stephen F. Austin State University; 2: University of Arkansas.