An Empirical Analysis of Market and Institutional Mechanisms for Alleviating Information Asymmetry in the Municipal Bond Market
Peng, Jun, Brucato, Peter F., Jr., Journal of Economics and Finance
This article examines how various market and institutional mechanisms resolve information asymmetry problems in the municipal bond market in the U.S. Information asymmetry exists in this market since a significant percentage of the investors are individuals on one side and many of the issuers are infrequent and relatively small ones on the other side. Using a two-stage switching regression model, we find that these mechanisms, including self-certification, method of sale, underwriter certification, and underlying credit ratings for insured municipal bonds, all help resolve information asymmetry problems and thus reduce borrowing cost for the issuers. (JEL G14)
This paper provides a theoretical and statistical model for understanding information asymmetry problems in the municipal bond market and how various institutional and market mechanisms have been set up at various stages of the issuance process to alleviate the problems.
Issuers of municipal bonds, as issuers of securities in other sectors of the capital market, suffer from various degrees of information asymmetry. Information asymmetry exists in the capital market when investors and issuers of financial securities do not share the same amount of information about the value of the securities. There are several reasons why information asymmetry happens in the primary municipal bond market. Many of the municipal bonds are sold by first-time and small issuers, who are usually not well known among the investment community. Based on data collected from Munilris, total number of issues with a face value of less than $10 million accounted for 70 percent of the total issues sold in 1998. At the same time, a significant portion of municipal bonds are purchased by individual investors. This combination makes information asymmetry a concern in the municipal bond market since doing credit analysis of a debt security is a more demanding task for individual investors than for financial institutions. Another important reason is that disclosure practice remains a concern in the municipal market, in terms of tardiness of reporting and inadequate disclosure of off-balance-sheet transaction.1
The most critical consequence of the information asymmetry problem is that issuers pay a higher borrowing cost than they should since investors will demand a higher risk premium to compensate them for the informational disadvantage. To alleviate such information asymmetry between the issuers and investors as well as the resulting higher capital cost for the issuers in the municipal bond market, several market and institutional mechanisms have been set in place over the past several decades. These certification mechanisms include, among others, method of sale (competitive versus negotiated), underwriter certification, and underlying credit rating for insured bonds. Through an empirical analysis, this study finds that all these certification mechanisms, independent of each other, play a role in alleviating information asymmetry and thus reducing borrowing costs to the issuers of municipal bonds. The more significant the information asymmetry problem, the more important the mechanisms are.
The rest of the paper is structured in the following order. The next section looks at various market and institutional mechanisms that correct such problem, and the one following discusses hypotheses, models, and data collection. Then empirical results are presented, and the final section concludes.
Market and Institutional Mechanisms
Various market and institutional mechanisms aimed at alleviating information asymmetry in the primary capital market generally can be categorized into two groups: self-certification and third-party certification. In self-certification, the issuer sends self-generated signals to the market about his quality in such ways that will be difficult for issuers of inferior quality to imitate. In third-party certification, the issuer relies on outsiders to reduce information disparity. …