Abstract
Favorable tax treatment of coupon income, and unfavorable treatment of capital gains, lead municipal bonds to be issued with coupon rates substantially above market rates and an accompanying original issue premium. We present evidence that the size of the original issue premium is a response to institutional investor preferences. Mutual fund and insurance company ownership is concentrated in bonds with an original issue premium that is more than double the premium of other municipal bonds. Institutional preference for premiums is largest when the protection provided by the premium is the most valuable, i.e., when the slope of the yield curve is steepest. For new municipal issues, the size of the original issue premium is increasing in institutional ownership at issue. Issuers offering premium bonds benefit from lower offering spreads. We interpret these results as evidence that municipalities design bonds with above-market coupon rates to attract institutional investors