Informed Investors and Underpricing in Municipal Bond Offerings

Abstract

This paper studies the effect of local mutual funds on municipal bond issuance. Offering yields are higher in states where municipal bond funds' headquarters are located, and in states with larger aggregate fund size. However, holding local fund size constant, yields decrease in the number of funds. Such relations hold when local funds' primary market participation is instrumented with the characteristic differences between new issues and existing bonds in fund portfolios. A security underpricing model that incorporates imperfectly informed investors confirms my empirical findings. Despite higher borrowing costs, issuers benefit from local funds' certification resulting in retail investors' higher demand.

Keywords: municipal bonds, IPOs, mutual funds, OTC markets, information asymmetry

JEL Classification: G12, G14, G23