ssrn municipal bond liquidity by

SSRN-Municipal Bond Liquidity by Lawrence Harris, Michael Piwowar

SSRN-Municipal Bond Liquidity by Lawrence Harris, Michael Piwowar:

Harris and Piwowar look at the liquidity of Municipal Bonds. Not

surprisingly they find that the bonds are not as liquid as stocks and

that transaction costs are MUCH higher.

While much of this illiquidty may be a function of the market itself,

at least some may be blamed on the issuers (and more importantly their

investment bankers). How? The authors report that transactions costs

increase with the complexity of the bonds. Why? If people do not

understand what the bond is offering, they are less likely to buy it.

As more people do not understand the bond, liquidity drops, and the

investors who are willing to trade the security demand a higher

premium. So it appears that simple plain vanilla bonds may be a better

option afterall.

In the authors' words:

"Unlike in equities, municipal bond transaction costs decrease with

trade size and do not depend significantly on trade frequency.

Municipal bond trades are also substantially more expensive than

similar sized equity trades. We attribute these results to the

general lack of price transparency in the bond markets. Additional

cross-sectional analyses show that bond liquidity increases with

credit quality and decreases with instrument complexity, time to

maturity, and time since issuance. The results suggest that

investors, and perhaps ultimately issuers, could benefit if issuers

issued simpler bonds. "

Interestingly this topic and, indirectly, this study was recently

(2/17/05) mentioned in the Houston Chronicle. Why? Because new changes

(Undoubtedly brought about in part by this study) have increased the

transparency (and hopefully will bring down the transactions costs for

the muni-bond market.

The rule change?

With the real-time pricing, which began Jan. 31, dealers are

required to report all trades within 15 minutes to the Municipal

Securities Rulemaking Board, which oversees the muni market. The

board posts the information on its Web site,

www.investinginbonds.com.

The Houston Chronicle reports that the new rule is working:

"Things have gotten better with next-day price transparency," Olson

says. "There aren't as many rogue practices. Brokers and traders

know they're being watched."

So it appears that Harris and Piwowar have helped to make a

difference! Good job!

Suggested Citation

Harris, Lawrence and Piwowar, Michael S., "Municipal Bond

Liquidity" (February 13, 2004). AFA 2005 Philadelphia Meetings.