Primary and secondary subnational debt markets
Author(s)
Riegel, Konul A.
Advisor(s)
Hildreth, W. Bartley
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Abstract
U.S. state and local (subnational) governments issue municipal bonds in the capital markets to finance infrastructure projects such as schools, roads, and bridges. These securities
are first sold in the primary municipal bond market and subsequently resold in the secondary market. This dissertation explores the primary and secondary subnational debt markets and their impact on state and local governments. The first chapter provides background information on the municipal bond market. The second chapter estimates the market-implied marginal tax rates associated with tax-exempt debt. The third chapter estimates the effect of the secondary municipal bond market on future cost of borrowing for debt-issuing governments. The fourth chapter explores why some securities trade thousands of times in the secondary market while most never trade. The fifth chapter concludes the dissertation and discusses relevant policy implications. The size of the subnational debt has surpassed $3:8 trillion as of the third quarter of 2017. Understanding the primary and secondary municipal bonds markets and the impact of these markets on issuers can allow thousands of debt-issuing state and local governments to save billions of dollars in borrowing costs. This is important because reducing borrowing costs, in turn, can free up funds for other public services such as education and health care. Debt is a crucial part of public finances. As such, this dissertation contributes to the public finance literature, particularly in the area of public financial management research. Chapter 1: Background. The majority of state and local governments in the U.S. have debt-issuing capacity. There is quite a bit of heterogeneity in the types of issuers and financial products that are issued in the municipal bond market. The variety of market participants (underwriters, dealer-brokers, etc.) add further complexity to the debt performance outcomes of issuers. The main feature that sets the muni market apart from other capital markets is the tax exemption of interest income - most municipal bonds are exempt from federal, state, and certain local income taxes. Chapter 2: Primary Market. Eliminating or limiting tax exempt-status of municipal bonds becomes a potential policy alternative in periods of budgetary distress, given that taxes foregone due to exemption amount to billions of dollars per year to the federal government. This chapter estimates the implied marginal tax rates associated with tax-exempt munis to understand the tax-reduction benefits accrued to state and local governments. In this analysis, tax-exempt munis are matched to near-identical taxable munis, which creates a unique quasi-experimental design. Results of the Random Coefficients Model (RCM), which accounts for issuer- and issuance-level unobserved effects, show significant heterogeneity in implied marginal tax rates across issuer types (e.g. counties vs. school districts) and over time. The longstanding muni puzzle, the finding that interest on tax-exempt bonds is higher than the theory would predict, disappears for general purpose governments, once the nested structure and the product and issuer heterogeneity of the municipal bond market are taken into account. Results imply that municipal forms of government benefit the most from the tax exemption, while special districts benefit the least. Chapter 3: Effect of the Secondary Market On the Primary Market. The primary market for state and local government borrowing receives great attention yet researchers as well as subnational debt-issuing governments tend to ignore the secondary municipal
bond market. However, if the primary market rewards the performance of the issuer’s outstanding debt in the secondary market, then state and local governments are neglecting an important piece of the puzzle and the potential to reduce future borrowing costs. This study combines large proprietary databases of primary and secondary market information to test whether the performance of existing debt in the secondary market affects future cost of borrowing for state and local governments. Results show that fluctuations in the secondary
market prices and yields impact future borrowing costs. Further, the effect of the secondary market varies significantly by issuer. Findings imply that the secondary market contains an additional layer of real-time quality information not captured by other lagged metrics such as credit ratings. Chapter 4: Secondary Market. The municipal bond market is full of peculiarities. One such puzzling fact is that some securities trade thousands of times in the secondary market while most do not trade at all. Studies have shown that these differences in trading
frequency cannot simply be attributed to transaction costs - actively traded bonds are not necessarily less expensive to trade. Understanding what accounts for such distinct patterns of trading activity can inform investors and issuers about market demand and potentially improve government debt issuance outcomes and household portfolio allocation decisions. This paper examines the dispersion of trading activity of municipal securities in the secondary market using large databases of security- and transaction-level information. Results show that safer and high quality securities tend to be taken off the market quickly and
most likely absorbed into the portfolios of buy-and-hold type investors. Further, the call complexity hypothesis reveals distinct trading patterns for different trade types (interdealer trades vs. retail customer trades) as the call date approaches. Finally, there is some evidence of speculative trading in the secondary market which further contributes to the wide dispersion in trading activity among various securities. Chapter 5: Conclusion. The first set of findings show that the effect of the municipal bond tax exemption policy are substantial. Smaller municipalities benefit the most from the ability to issue tax-exempt munis. Second, I find that the secondary market contains an additional layer of real-time quality information not captured by other lagged metrics such as credit ratings. This information contained in the secondary market performance of
the issuer’s existing debt has a direct impact on future borrowing costs for state and local governments. Finally, hyper-trading in secondary market for municipal bonds is explained using several conceptual frameworks, such as portfolio absorption, speculative trading, and call complexity.
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Date
2018-04-04
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Dissertation