Municipal Bond Liquidity and Default Risk

55 Pages Posted: 15 Mar 2014 Last revised: 8 Nov 2016

Date Written: September 16, 2016

Abstract

This paper examines the pricing of bonds issued by states and local governments. I use three distinct, complementary approaches to decompose municipal bond spreads into default and liquidity components, finding that default risk accounts for 74% to 84% of the average municipal bond spread after adjusting for tax-exempt status. The first approach estimates the liquidity component using transaction data, the second measures the default component with credit default swap data, and the third is a quasi-natural experiment that estimates changes in default risk around pre-refunding events. The price of default risk is high given the rare incidence of municipal default and implies a high risk premium.

Keywords: municipal bonds, credit risk

JEL Classification: G12, H74

Suggested Citation

Schwert, Michael, Municipal Bond Liquidity and Default Risk (September 16, 2016). Journal of Finance, Forthcoming, Fisher College of Business Working Paper No. 2016-03-16, Charles A. Dice Center Working Paper No. 2016-16, Available at SSRN: https://ssrn.com/abstract=2408867 or http://dx.doi.org/10.2139/ssrn.2408867

Michael Schwert (Contact Author)

AQR Arbitrage, LLC ( email )

Two Greenwich Plaza
Greenwich, CT 06830
United States
2037423005 (Phone)

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