Do Municipal Bond Prices Reflect Internal Control Quality?

55 Pages Posted: 1 May 2016 Last revised: 24 Aug 2023

See all articles by Angela K. Gore

Angela K. Gore

George Washington University - School of Business

Brian J. Henderson

George Washington University - Department of Finance

Yuan Ji

The University of Texas at Arlington

Date Written: May 22, 2023

Abstract

We examine whether internal control problems are priced in municipal bond markets. Government sector internal control problems are frequent, slow to be corrected, and increase the probability of future restatements, fraud, and waste of public resources. Using a generalized staggered difference-in-differences design, primary findings are that municipal bond prices are an economically substantial 5 – 28 basis points higher during years when municipalities have a material weakness in internal controls. Prices are not significantly different during years when governments have significant deficiencies, suggesting the bond market does not differentiate more minor accounting problems. Findings are magnified under circumstances of greater information uncertainty, such as for revenue bond issuances and delayed release of financial information. Additional analysis suggests findings are primarily driven by retail investor trades. Moreover, bonds issued by governments with material weaknesses remain in underwriter inventory significantly longer before eventual sale to investors. Overall, our evidence has two primary implications: first, municipal bond prices reflect compensation to underwriters for the additional inventory holding risk and effort involved in placing bonds issued by municipalities with serious internal control problems; second, dealers may take advantage of retail investors by placing riskier bonds with them.

Keywords: municipal bonds; markups; internal controls; material weakness; entropy balancing; cbps

JEL Classification: G38, H79, K22, M41, M45

Suggested Citation

Gore, Angela K. and Henderson, Brian Joseph and Ji, Yuan, Do Municipal Bond Prices Reflect Internal Control Quality? (May 22, 2023). Available at SSRN: https://ssrn.com/abstract=2772605 or http://dx.doi.org/10.2139/ssrn.2772605

Angela K. Gore (Contact Author)

George Washington University - School of Business ( email )

2201 G St NW
Washington, DC 20052
United States
(202) 994-6195 (Phone)

Brian Joseph Henderson

George Washington University - Department of Finance ( email )

Department of Finance, Funger Hall
2201 G Street, NW
Washington, DC 20052
United States
202-994-3669 (Phone)

Yuan Ji

The University of Texas at Arlington ( email )

701 S. West Street
Room 409
arlington, TX TX 76010
United States

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