The municipal bond market tends to be less active largely because of how municipal securities are taxed. Municipal bonds are tax-free for investors who live in the issuing state (and sometimes the issuing city). Because of that, investors who buy and sell municipal bonds often prefer to trade with other investors in the same state or locality. Depending on the size of the municipality, the number of potential traders can be small.
In general, the municipal bond market is illiquid. An illiquid security is harder to sell quickly at a fair price. The harder it is to sell, the less active its market tends to be. Municipal bonds are subject to liquidity risk, which is the risk that an investment can’t be sold when you want to sell it, or that it can only be sold by accepting a significant discount.
We first learned about short selling in the common stock unit. Investors sometimes sell stocks or bonds short, but municipal bonds are rarely sold short. In a short sale, an investor borrows a security, sells it right away, and then hopes to buy it back later at a lower price. The goal is to sell first and buy second, profiting if the market price falls.
Municipal bond short sales are rare because of liquidity risk. Suppose you sell short a municipal bond expecting 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 repurchase it, you can’t close out the short position. For that reason, municipal bonds generally aren’t sold short.
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 (NYSE). Municipal bond transactions occur in the OTC markets, which connect buyers and sellers without the structure of an exchange. We’ll cover the OTC markets in more detail in the secondary market unit.
We learned how corporate bonds are quoted as a percentage of par in 1/8ths in a previous chapter. Municipal bond quotes often look different because they’re typically quoted in yields, like this:
7% municipal bond trading on a 5% basis
Without a financial calculator and more details, you can’t determine the exact price from that quote alone. You can, however, tell whether the bond is trading at a discount or a premium.
From the bond fundamentals unit, remember: a bond trades at a premium when its YTM is lower than its coupon. In this quote, the YTM (5%) is lower than the coupon (7%), so the bond is trading at a premium.
Most municipal bonds are quoted this way, but not all. Municipal dollar bonds (often revenue bonds) are quoted like corporate bonds: as a percentage of par in 1/8ths. For the SIE exam, you’ll usually be expected to assume municipal bonds are quoted in yields.
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