The Option Value of Municipal Liquidity: Evidence from Federal Lending Cutoffs during COVID-19

We estimate the option value of municipal liquidity by studying bond market behavior and public sector hiring decisions when government budgets are severely distressed. Using a regression discontinuity (RD) design, we exploit lending eligibility cutoffs introduced by the Federal sector’s Municipal Liquidity Facility (MLF) in April 2020 to study the effect of an emergency liquidity option on yields, primary issuance, credit downgrade probability, and public sector employment. We find that while the announcement of the liquidity option improved overall municipal bond market functioning across the board, low-rated issuers additionally benefited from direct access: low-rated government bonds traded at higher prices and were issued more frequently on private markets with facility access. This suggests the presence of a credit-risk sharing channel on top of the Fed’s role as liquidity-provider of last resort. In contrast to investors, local governments responded to the liquidity option by retaining a greater share of public sector employees across the entire ratings distribution.The results imply municipal debt markets and employment outcomes would likely have been more distressed absent the MLF, and are consistent with the view that large government furloughs might have over-weighted the worst possible outcomes based on past experience.