Municipal markets

The municipal bond market tends to be less active largely because of how municipal bond interest is taxed. Municipal bond interest is generally tax-free for investors who live in the state (and sometimes the city) that issued the bond. As a result, most trading happens among investors within the same state or locality. Depending on the size of the municipality, that can mean there are relatively few potential buyers and sellers.

Generally speaking, the municipal bond market is illiquid. If a security is illiquid, it isn’t easy to sell quickly at a fair price. The harder a security is to sell, the less active its market tends to be. Municipal bonds are subject to liquidity risk, which occurs when an investment is difficult to sell or requires a large discount to sell.

We first learned about short selling in the common stock chapter. Investors sometimes sell short stocks or bonds, but municipal bonds are rarely sold short. Remember, selling short means an investor borrows a security, sells it right away, and then hopes to buy it back later at a lower price. In other words, the investor sells first and buys second, betting the market price will fall.

Municipal bond short sales are rare because of liquidity risk. Suppose you sell short a municipal bond because you expect its price to drop. A few months later, you might go to the market and find that no one is trading that bond. If you can’t buy it back, you can’t close out the short position. For that reason, most broker-dealers won’t allow customers to sell short an illiquid security, and municipal securities are known for being illiquid.

Municipal bonds trade in the over-the-counter (OTC) markets, meaning they don’t trade on exchanges. Exchanges are centralized venues where investors trade securities, like the New York Stock Exchange. Municipal bond transactions occur in the OTC markets, which connect buyers and sellers without the oversight of an exchange. We’ll learn more about the OTC markets in the secondary market chapter.