Municipal Bond Liquidity and Default Risk

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.