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

State and local governments rely on municipal bonds to finance investments in infrastructure. They are often complex financial products, specifying a variety of special provisions, such as flexible maturities and unique redemption clauses. Such provisions in a bond may be tailored to the financial needs of investors and the issuing local government, but they may also make it difficult to evaluate and compare alternatives. Using detailed data on bond transactions, the project will quantify the effects of bond provisions on market liquidity, intermediary competition, and cost of local government funding. The insight from this analysis will have implications for policies on municipal bond market structure, the cost of local government funding, and infrastructure investment costs.

The project will highlight the impact of product attributes on search frictions in the municipal bond market. The research will document how financial institutions' dual role as underwriters and dealers may affect product design, steering toward highly customized and complex products. Exploiting variations in state regulations to limit government officials' conflicts of interests, the project will investigate how special provisions in a bond may increase both its illiquidity and its underwriter’s market power in secondary trades. Building on these findings, the research will construct and estimate a model of bond issuance and trades, which accounts for rich heterogeneity in the factors that affect bond design: Investor demand, dealer costs, and issuer preferences. Employing the estimated model, the project will quantify market inefficiency and discuss policy implications.