Municipal Bond Liquidity and Default Risk
Charles A. Dice Center Working Paper No. 2016-16
55 Pages Posted: 15 Mar 2014 Last revised: 8 Nov 2016
Date Written: September 16, 2016
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: Suggested Citation