Collaborative Research: Intermediaries and Product Selection in the Municipal Bond Market

Project Outcomes Statement

This project examined how complexity in financial products—specifically, municipal bonds—can affect government borrowing costs and market efficiency. Municipal bonds are used by state and local governments to fund public infrastructure such as schools, roads, and water systems. While these bonds often come with standard features, governments sometimes include customized provisions that can make them more difficult to trade, raising concerns about transparency and cost.

Our research focused on how these "nonstandard" bond features impact market dynamics, and whether intermediaries like underwriters have incentives to promote complexity for their own benefit. We also explored how policies that encourage simpler, more standardized bonds might affect outcomes for governments, investors, and taxpayers.

To do this, we combined large datasets on bond issuance and trading with detailed information about institutional rules, specifically “revolving-door” laws that restrict government officials from joining firms they previously regulated. These laws helped us identify how underwriters' incentives might shape bond complexity. We also developed and estimated an economic model to simulate how changes in bond design and regulation could affect market outcomes.

We found that when underwriters have greater influence over bond design, they are more likely to include nonstandard features that benefit them in the resale market. These features tend to make bonds harder for investors to compare and trade, leading to higher costs for buyers and potentially higher profits for dealers. However, these customized provisions also offer benefits—such as allowing governments to better align bond payments with their expected cash flows—suggesting that some complexity may be desirable.

Using our model, we examined a policy that would mandate standardization of all municipal bonds. We found that this policy would improve market liquidity and investor welfare, and would reduce interest payments by about 9% on average. However, the benefits are not evenly distributed. The largest savings accrue to low-income counties, while many other governments might lose the flexibility they need to manage public finances. These findings highlight an important tradeoff: while standardization could reduce costs and improve efficiency, it might also limit governments’ ability to tailor financial tools to their specific needs.

Throughout the project, we also trained PhD students and undergraduates, providing them with hands-on research experience in data analysis and economic modeling. The findings were presented at top universities and leading economics conferences, contributing to academic and policy discussions on municipal finance and public infrastructure investment.

In sum, this project offers new insights into how financial product design can shape market outcomes and government costs. It informs ongoing debates about transparency, market efficiency, and the role of regulation in the public finance sector.