[Remember_Salamis]

"Interest rates are determined by supply-demand forces and it is not clear that the assumption holds. In fact, it is not easy to say precisely what would happen, but I personally doubt that taxable rates will drop to nontaxable rates. I believe that previously taxable rates will drop substantially when they become non-taxable, but to a level higher than current non-taxable rates. And current non-taxable rates will rise slightly until they meet.

Actually, they won't meet, because if you could choose between a AAA insured municipal and a federal bond at the same rate, you would always choose the federal for liquidity reasons."

-- A taxable bond with the same risk rating as a non-taxable bond WILL meet. If not, explain to me why a corporate bond issuer would pay out more in interest than he had to? If they were callable, he would drop his rates in a heartbeat.

[undeniable logic]

They won't meet because they are less liquid. I am currently doing research on municipal bond spreads. The average buy-sell spread, even for a pre-refunded bond (this is even less risky than a federal bond), is around 2 percent. Knowing that if you want to sell the bond, you take a 2 percent hit, why would you accept the same rate for a federal bond where the spread is practically nil? You wouldn't.

In reference to your example, a corporate bond issuer will pay out more interest, because he has no choice - people charge a premium for illiquidity, and corporate and municipal bonds are simply less liquid then federal bonds.