Flight to Liquidity or Safety? Recent Evidence from the Municipal Bond Market

Abstract

We examine the impact of the COVID-19 pandemic and subsequent monetary and fiscal policy actions on municipal bond market pricing. Using high-frequency trading data, we estimate key policy events at the peak of the crisis by focusing on a sample of bonds within a very narrow window of just before and just after each event. We find that policy interventions, in particular those with explicit credit backstops, were effective in stabilizing the municipal bond market. In addition, by exploiting daily variation in traded municipal bonds and virus exposure across U.S. counties, we find that prior to the policy interventions, COVID-related credit risks were a significant component of elevated short-term bond yields. Following the interventions, however, the pricing of localized credit risks declined for short-maturity bonds, but became more notable for longer-maturity bonds. The shift in credit risk pricing reflects policy interventions being targeted on short-term bonds, as well as investors’ expectation of long-lasting recessional impacts on state and local government budgets.