Flight to Liquidity or Safety? Recent Evidence from the Municipal Bond Market

We examine the effects of the COVID-19 pandemic and subsequent monetary and fiscal policy actions on municipal bond market pricing. Using high-frequency trading data, we estimate key policy events at the peak of the crisis by focusing on a sample of bonds within a narrow window before and after each policy event. We find that policy interventions, in particular those with explicit credit backstops, were effective in alleviating municipal bond market stress. Next, we exploit daily variation in traded municipal bonds and virus exposure across U.S. counties. We find a shift in how bond investors priced in localized COVID risks before and after the suite of policy interventions was introduced. Prior to the policy interventions, COVID-related credit risks were a significant component of elevated short-term bond yields. Following the interventions, however, the pricing of localized credit risks declined for short-maturity bonds, but became more notable for longer-maturity bonds. The shift in credit risk pricing reflects policy interventions being targeted on short-term bonds, as well as investors’ expectations of long-lasting recession effects on state and local government budgets.