Trading Activity and Price Volatility in the Municipal Bond Market

Abstract

Utilizing a comprehensive database of transactions in municipal bonds, we investigate the volume-volatility relationship in the muni market. We find a positive relationship between the number of transactions and a bond's price volatility. In contrast to previous studies, we find a negative relationship between average deal size and price volatility. These results are found to be robust throughout the sample. Our results are inconsistent with current theoretical models of the volume-volatility relationship. These inconsistencies may arise because current models fail to account for the effects of overall market liquidity on the costs of large transactions.

Taxes on Tax‐Exempt Bonds

“…Table VI reports transaction spreads (the yield difference between dealer sales to customers and dealer purchases from customers) of below‐de minimis and above‐revised price transactions between dealers and customers averaged across the sample. We observe that for retail‐to‐dealer transactions, retail investors pay a steep price in terms of the transaction spread, consistent with the evidence documented by, among others, Downing and Zhang (2004), Harris and Piwowar (2006), and Green et al (2007a). For fully tax‐exempt bonds, the difference in yields between retail sales to dealers and retail purchases from dealers is a large 18.74 + 18.99 = 38 basis points.…”

“…Finally, municipal bond markets are generally illiquid. Downing and Zhang (2004), Hong and Warga (2004), Harris and Piwowar (2006), and Green, Hollifield, and Schürhoff (2007a), among others, find large trading costs, especially for retail customers in the municipal bond market. We purge all transactions with par amounts traded below $10,000 from our sample to minimize these effects.…”

Corporate Bond Market Transparency and Transaction Costs

“…Chen et al (2002) examine credit risk across both highyield and investment grade corporate bonds, but their results are mixed at best. For municipal bonds, Downing and Zhang (2004) find increases in volatility with more credit risk and Harris and Piwowar (2004) find that bonds with higher credit risk are more expensive to trade. We find that secondary corporate bond transaction costs increase with credit risk.…”

Secondary Trading Costs in the Municipal Bond Market

“…1313 See, for example, Sarig and Warga (1989), Amihud and Mendelson (1991), Blume, Keim, and Patel (1991), Cornell and Green (1991), Warga (1992), Elton and Green (1998), Alexander, Edwards, and Ferri (2000a,b), Hotchkiss and Ronen (2002), Hotchkiss, Warga, and Jostova (2002), Kalimpalli and Warga (2002), and Downing and Zhang (2004). …”