Municipal Bond Risk Premia During the Financial Crisis: Model and Implications

This study examines investors’ risk-averse behavior in the municipal bond market during the financial crisis of 2008. It employs a dataset from 1989 to 2014 and the Box-Jenkins time series technique to estimate the yield spreads of short-term and longterm fixed income securities. The results demonstrate that the short-term risk premium increased dramatically over the event window but did not persist, while the observed long-term risk premium increased less dramatically, but fluctuated more and lasted longer. The point estimates show that the financial crisis cost short-term issuers an average of 134 basis points in interest costs, whereas long-term issuers paid an average of 100 basis points more than they would have. These findings suggest that when facing a severe financial crisis, municipal issuers should consider adjusting the timing of bond issuance, solve informational asymmetries to the extent possible, and be very cautious about using pricing estimates based on risk-neutral models.