Harris and Piwowar look at the liquidity of Municipal Bonds. Not surprisingly they find that the bonds are not as liquid as stocks and that transaction costs are MUCH higher.
While much of this illiquidty may be a function of the market itself, at least some may be blamed on the issuers (and more importantly their investment bankers). How? The authors report that transactions costs increase with the complexity of the bonds. Why? If people do not understand what the bond is offering, they are less likely to buy it. As more people do not understand the bond, liquidity drops, and the investors who are willing to trade the security demand a higher premium. So it appears that simple plain vanilla bonds may be a better option afterall.
In the authors' words:
"Unlike in equities, municipal bond transaction costs decrease with trade size and do not depend significantly on trade frequency. Municipal bond trades are also substantially more expensive than similar sized equity trades. We attribute these results to the general lack of price transparency in the bond markets. Additional cross-sectional analyses show that bond liquidity increases with credit quality and decreases with instrument complexity, time to maturity, and time since issuance. The results suggest that investors, and perhaps ultimately issuers, could benefit if issuers issued simpler bonds. "Interestingly this topic and, indirectly, this study was recently (2/17/05) mentioned in the Houston Chronicle. Why? Because new changes (Undoubtedly brought about in part by this study) have increased the transparency (and hopefully will bring down the transactions costs for the muni-bond market.
The rule change?
With the real-time pricing, which began Jan. 31, dealers are required to report all trades within 15 minutes to the Municipal Securities Rulemaking Board, which oversees the muni market. The board posts the information on its Web site, www.investinginbonds.com.The Houston Chronicle reports that the new rule is working:
"Things have gotten better with next-day price transparency," Olson says. "There aren't as many rogue practices. Brokers and traders know they're being watched."So it appears that Harris and Piwowar have helped to make a difference! Good job!
Harris, Lawrence and Piwowar, Michael S., "Municipal Bond Liquidity" (February 13, 2004). AFA 2005 Philadelphia Meetings. http://ssrn.com/abstract=503062