Essays on the Municipal Bond Market

The municipal bond market is a financial market that does not draw much attention from academics, researchers, the government or practitioners. However, that changed recently when the largest recession since the Great Depression impacted the U.S. economy. Now everyone is struggling to understand two major questions: 1) How do we mark to market bonds in illiquid markets? and 2) Why are 50% of new issues insured in a market that has the lowest default rate of any bond market other than the treasury market? This dissertation examines those questions in three parts./nThe first part, The Effect of Insurance on Municipal Bond Yields, studies the difference between insured and uninsured municipal bond yields. I find that although some of that difference is attributable to the effect of insurance, another channel comes from self selection to insure -- municipalities that choose to insure differ significantly from municipalities who choose not to insure. Without accounting for the latter self selection the insurance benefit appears undervalued. By focusing on municipalities with both outstanding insured and uninsured bonds (mixed municipalities), I identify that in the pre-crisis period insurance for such municipalities reduces municipal bond yields by 8 basis points. But analysis of homogeneous municipalities reveals the self selection effect raises yields by 6 basis points. However, during the recent financial crisis, insurance continued to lower yields by 8 bps, whereas the self selection effect increased yields by 18 basis points. Thus, my work explains the recent initially puzzling phenomenon when insured yields rose above uninsured yields./nThe second part, The Effect of Insurance on Liqudity, examines liquidity in the municipal bond market during the recent financial crisis. I analyze the effects of insurance on liquidity for municipal bonds and estimate how the effects of insurance change when the insurers face a loss of capital and rating downgrades. I measure liquidity in the three ways most suited for illiquid markets: the Amihud measure, Roll's bid-ask measure, and turnover. By all three measures, both before and after the financial crisis, bonds with insurance are less liquid than bonds without insurance. I also find that the liquidity of bonds with insurance decreases over the financial crisis. These findings indicate that insurance does not improve liquidity./nThe third part, A Municipal Bond Market Index Based on a Repeat Sales Methodology, introduces a repeat sales methodology to create an index for the municipal bond market based on transactional prices, because the current indices are based on estimated bond prices. The repeat sales methodology can calculate an index for any municipal bond characteristic. I create and analyze indices for the municipal bond market and separate indices by rating, maturity, and characteristics such as insurance and bond type (i.e. General Obligation or Revenue). Repeat sales methodology is based on the assumption that characteristics of the bond do not change over time which means the movements in bond prices are due to evolving market conditions. I compare the repeat sales indices with the existing municipal bond indices and find the repeat sales indices highly correlated with the current indices with a correlation of .8.

Advisor: Jaffee, Dwight M