Risk and information in the municipal bond market.

• Author: Ang, Andrew
• Position: Research Summaries

Municipal bonds--munis--are issued by states, local governments, and other tax-exempt entities to raise money for roads, schools, utilities, public buildings, and other infrastructure investments. Totaling $3.7 trillion at the end of 2013, with approximately $400 billion in new issuance every year, the muni market is roughly one-third the size of the U.S. Treasury market. There are 50,000 issuers of municipal securities. Individual investors hold approximately 80 percent of all munis, either directly or indirectly through intermediated funds. There are three main ways in which munis differ from bonds issued by the federal government: (1) they have higher default risk, (2) they are much less liquid, in part because information in the muni market is limited, decentralized, and non-standardized, (3) and the interest earned on most munis is exempt from federal income tax.

In the area of muni default risk, Francis Longstaff and I compare the credit risk of large U.S. states with major Eurozone countries. (1) This comparison is interesting and timely because many U.S. states, like Michigan and Illinois, are fiscally challenged, as are several European countries, like Spain and Portugal. Second, states pack roughly the same economic punch as European countries: California's economy is larger than Spains and approximately 90 percent the size of Italy's, and Michigan has an economy larger than that of Greece, Portugal, or Ireland.

Third, both states and Eurozone countries are in currency unions--of the U.S. dollar and the Euro, respectively. There are many economic, legal, and political linkages between states, just as there are similar, but weaker, linkages among European countries. Most importantly, states are sovereign borrowers under the U.S. Constitution and there is no bankruptcy mechanism for state default, just as there is no institutional bankruptcy mechanism for any sovereign borrower. Both U.S. states and Eurozone countries have previously defaulted. Spain, Austria, and Greece defaulted in the 1930s and 1940s. Greece most recently defaulted in 2012. U.S. states have also defaulted: eight states went bankrupt in the 1830s and 1840s, ten states defaulted during the late 1800s, and the last state to default was Arkansas in 1933. We compare U.S. state and European country credit risk estimated from Credit Default Swap (CDS) contracts, in which purchasers of default protection receive a payoff when a sovereign defaults and in the meantime make regular, insurance-like payments to the providers of default protection. In our pricing model, defaults are triggered by two sources. First, Portugal may default because of an event specific to Portugal that does not affect other countries. Second, a Europe-wide shock could trigger a Portuguese default. Similarly, if the U.S. defaults, this might cause Illinois to default (exposure to systemic risk), but Illinois might also default...