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IntroductionTHE YIELDS OF municipal bonds and corporate bonds are often compared. The ratios of municipal bond yields to corporate bond yields are thought by many to be indicative of the marginal tax bracket of the marginal holder of the bonds. If, for example, the ratio is .60, the implication is that an investor in the fortypercent tax bracket will be indifferent between the fully-taxed corporate and the fully tax-exempt municipal. (This assumes that the two bonds are currently selling at par.) Such comparisons have attracted increased attention since the publication of Merton Miller's seminal "Debt and Taxes". In this work Miller indirectly suggests that the marginal tax bracket at work across tax-exempt and taxable bonds is equal to the corporate tax rate. While the ratio of yields seems to indicate that this is true for short-term bonds, the yields of long-term taxexempts seem too high relative to long-term taxables to confirm Miller's hypothesis. Implicit in these comparisons and the conclusions drawn from them is the tenuous notion that the compared bonds are identical except for the taxability of the coupon. For example, some authors have questioned whether municipals and corporates are equally risky. (See Trzcinka [1982]). The purpose of this paper is to present preliminary evidence on the relative riskiness of the two classes of bonds. Relative Risk Why might the risks of municipal bonds differ from those of similar corporate bonds? Several plausible explanations are possible. Suppose, for example, increases in taxable interest rates lead to reduced demand for tax-sheltered investments by the holders of tax-exempt bonds. If this is the case, changes in taxable bond prices may be accompanied by even-larger changes in tax-exempt bond prices. Consider the following illustrations.Commercial banks hold approximately one half of the municipal bonds outstanding. Banks have a unique opportunity to arbitrage across short-term taxexempt and taxable bond markets; that is, they are allowed a deduction for interest paid on CD's while, at the same time, receiving tax-exempt coupon payments. This privilege ensures that short-term municipal yields are normally very near to the after-corporate-tax yield on CD's. But this arbitrage by banks is not always profitable or possible. In order for the deduction for interest expense to be valuable, the bank must have sufficient taxable income and when interest