The municipal bond market is inactive primarily because of how municipal securities are taxed. If you recall, municipal bonds are tax-free for investors that are residents. When people trade municipal bonds, they almost always transact with other 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. An illiquid security is challenging to sell; the more difficult it is to sell, the less active its market is. Municipal bonds are subject to liquidity risk, which occurs when an investment cannot be sold or requires a significant discount to be sold.
We first learned about short selling in the common stock unit. It’s not unusual for investors to sell short stock or bonds, but municipal bonds are rarely sold short. Selling short involves an investor borrowing a security, selling it immediately, and hopefully repurchasing it at a lower price. Essentially, it’s backward investing. The investor bets 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 repurchase it? You wouldn’t be able to, so municipal bonds are generally not sold short.
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 (NYSE). 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 unit.
We learned how corporate bonds are quoted as a percentage of par in 1/8ths in a previous chapter. Municipal bond quotes appear considerably different as they are typically quoted in yields, which look like this:
7% municipal bond trading on a 5% basis
Without a fancy finance calculator and a bit more information, you won’t be able to find the specific price of the bond quoted above. However, you can determine if it’s trading at a discount or a premium. The first percent cited (7%) is the coupon, while the basis (5%) represents the yield to maturity (YTM). If you recall from the bond fundamentals unit, a bond is trading at a premium if its YTM is lower than the coupon.
Most municipal bonds are quoted this way, but not all. Municipal dollar bonds, usually revenue bonds, are quoted like corporate bonds as a percentage of par in 1/8ths. The SIE exam will likely stick to generalities, so you should assume municipal bonds are quoted with yields.
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