Investors’ Financial Conditions and Municipal Bond Pricing

Abstract

We investigate whether the financial conditions of insurance companies, an important group of investors in the market, can affect the municipal bond spreads. Using Hurricane Sandy as an exogenous shock to the financial conditions of insurers, we find that even not directly affected by Sandy, the municipal bonds held by Sandy-shocked insurers experience a widening of spreads during the event, compared to bonds not held by shocked insurers. Thus the Sandy case highlights the unexpected spillover effect of the natural disasters from Sandy-shock bonds to non-shocked bonds through the common ownership by Sandy-shocked insurers. The widening of spreads is caused by the actual sale and the potential sale pressure by the shocked insurers during Sandy, as we find that the increase in spreads also exists in bonds which are not actually sold by the shocked insurers, suggesting the effect of potential selling risk: investors’ financial conditions can affect pricing even though they are not engaging in trading. In a more general setting, we continue to find that weak financial conditions are related to higher bond spreads, which become even stronger during the Lehman crisis. We document that the increase in bond spreads is mainly driven by the increase in bond liquidity spreads. We further show that investor’s financial conditions affect the liquidity spreads by affecting the level of liquidity and liquidity commonality.