Kent Hiteshew and Ivan Ivanov write that the United States municipal bond market suffers from fragmentation, poor liquidity, and inadequate disclosure due to the dominance of small, infrequent issuers who struggle to meet regulatory disclosure requirements. They argue that greater involvement of state-backed municipal bond banks could help address these issues by pooling smaller issuances, reducing borrowing costs, and streamlining disclosure obligations for local governments.
This article is part of a series examining the financial conditions of local governments in the United States and the forces that shape them. We will publish a new addition to the series every Monday for the next few weeks.
The United States municipal bond market is distinctly more fragmented and less liquid and transparent than the U.S. treasury, corporate bond, and mortgage markets. As a result, municipal bond trading and pricing is both more opaque and less efficient than these other fixed income markets.
The Securities and Exchange Commission (SEC), through the industry’s self-regulatory body, the Municipal Securities Regulatory Board (MSRB), has attempted to remedy the disclosure deficiencies by mandating timely disclosure of material information from municipal issuers since 1989 via Rule 15(c)2-12. This regulation builds on the “limited regulatory scheme” of the municipal bond market put in place by the Tower Amendment in 1975 and has significantly expanded the scope of investor-relevant information between 1989 and 2018. Under this regulation, most municipal bond issuers are now required to report annual financial statements and provide timely disclosures of material events such as debt service delinquencies and defaults, non-payment covenant defaults, unscheduled reserve fund draws, adverse tax opinions, credit rating changes, bond calls, tender offers, and private debt placements, among others.
Despite these regulatory requirements and notable enforcement efforts, disclosure is often scant and delayed, especially among smaller issuers. Academics and practitioners alike have pointed out the limited nature of investor-relevant information in this market. Most recently, Ivanov, Zimmermann, and Heinrich (2024) document that issuers fail to report 50-60% of material events that are required under the latest round of SEC regulation. The latest round of regulation came about after the substantial increase in municipal private placements with banks and other sophisticated investors in the aftermath of the Great Financial Crisis, posing risks to municipal bond investors (Ivanov and Zimmermann, 2023).
While the SEC’s lack of direct supervisory authority over municipal issuers may be partly to blame for the poor disclosure regime, the fragmentation of the municipal market may also be a major contributor. Issuance in this market is dominated by small local governments that issue infrequently in small denominations resulting in over three million distinct CUSIPs between 2000 and early 2023. Most of the outstanding par amount of bonds were issued by just several hundred of the largest issuers, while the overwhelming balance of issuers account for only a fraction of outstanding debt. Naturally, these small entities struggle to provide the level and timeliness of ongoing disclosures required of a well-functioning, transparent, and liquid municipal bond market.
Pricing, liquidity, and transparency in the municipal bond market would benefit from a reduction in the number of these smaller issuers as it is easier for larger, more frequent, and sophisticated issuers to comply with the robust and timely disclosures required of well-functioning capital markets. Instead, properly structured state-wide municipal bond banks could provide smaller local governments with continued access to capital while improving the overall market’s pricing and liquidity. By pooling small, infrequent issuances into larger, more regular issuance by a state agency with strong capital market identity, the cost of capital in the form of both interest rates and upfront issuance costs could be reduced for smaller local governments.
However, the pooling function of bond banks alone would not necessarily address the poor secondary market disclosure compliance common among many smaller issuers. So long as a bond bank is simply a conduit issuer of pooled individual borrowers, each underlying borrower would continue to be subject to the continuing disclosure requirements of Section 15(c)2-12 and its attendant administrative burdens and costs.
Both the cost of capital and disclosure requirements for small issuers could be further reduced if a municipal bond bank were additionally provided a state “credit enhancement” feature. This enhancement would serve to homogenize the underlying pooled borrowers into a single, strong credit reflecting the quality of both the diversified underlying pool of borrowers and the state credit support feature. This would eliminate the need for disclosure from each borrower in the pool and limit the bond bank’s ongoing disclosure requirements to its own annual financial statements and events related to the overall financial performance of the borrower pool. A strong state-backed credit with larger, more frequent issuance would also support improved secondary market liquidity that, together with more robust and timely ongoing disclosure, would further reduce small government interest costs.
In return for assuming credit risk and passing on borrowing cost savings to smaller local governments, the bond bank would require fiscal monitoring and debt enforcement powers. Local governments would provide the bond bank with the same credit pledges (e.g. general obligation or revenue) they previously used to secure direct market offerings along with fiscal reporting as determined by the bond bank. As state-level agencies, bond banks are more likely to be staffed by finance professionals with extensive bond issuance and compliance experience than small local governments where officials often have limited capital markets expertise.
While there are few active bond banks with the requisite state credit enhancement feature described above, Maine, New Hampshire and Vermont have long, successful histories of operating these types of bond banks. All three bond banks have strong AA credit ratings and provide credit enhancement through state-aid-intercepts and moral obligation-backed reserve fund replenishment pledges. Participating local governments benefit from lower cost capital and reduced administrative cost burdens of ongoing secondary market disclosure. Together, Maine, New Hampshire and Vermont have provided billions of dollars of financing on behalf of their local governments dating back over 25 years.
Issuing publicly traded securities carries certain obligations and responsibilities, including robust and timely ongoing financial disclosure, to ensure properly functioning, transparent and liquid markets. Many smaller or less sophisticated issuers may not have the resources, staffing and systems available to meet these requirements. There may be other sources of funding, such as bank loans and municipal bond banks, that may be more appropriate to meet the capital financing needs of smaller issuers.
The views expressed are solely those of the authors and not those of the Federal Reserve Bank of Chicago or the Federal Reserve System.
Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.
