Municipal markets

The municipal bond market is inactive due to the way municipal bonds are taxed. If you recall, municipal bonds are tax-free for investors that are residents of the municipality. When people trade municipal bonds, they’re almost always trading solely with investors in their city or state. Depending on the size of the municipality, the number of municipal bond traders can vary.

Generally speaking, the municipal bond market is illiquid. If a security is illiquid, it is not easy to sell. The more difficult a security is to sell, the less active its market is. Municipal bonds are subject to liquidity risk, which occurs when an investment is difficult to sell or requires a large discount to be sold.

We first learned about short selling in the common stock chapter. It’s not uncommon for investors to sell short stock or bonds, but municipal bonds are rarely sold short. As a reminder, selling short involves an investor borrowing a security, selling it immediately, and hopefully buying it back at a lower price. Essentially, it’s backward investing. The investor is betting the market price falls by selling first and buying second.

Municipal bond short sales are rare due to their liquidity risk. Assume you sell short a municipal bond, hoping that its price drops. A few months later, you may go to the market and find no one is trading your municipal bond. How do you close out the short position if you can’t buy it back? You wouldn’t be able to. Most broker-dealers will not allow their customers to sell short an illiquid security, and municipal securities are notorious for their illiquidity.

Municipal bonds trade in the over-the-counter (OTC) markets, which means they do not trade on exchanges. Exchanges are centralized venues where investors trade securities, like the New York Stock Exchange. Municipal bond transactions always 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.