Ebook Debt Maturity, Credit Risk, and Information Asymmetry: The Case of Municipal Bonds
The debt maturity literature (see for example Flannery, 1986; Diamond, 1991; Berger, Espinosa-Vega, Frame, and Miller, 2005; Bali and Skinner, 2006) emphasizes the importance of credit risk and information asymmetry in the debt maturity decision for corporate firms. In the absence of information asymmetry, issuers tend to match debt maturity to asset maturity to minimize debt agency problems.
Under information asymmetry, credit quality of the issuer influences debt maturity. High quality firms prefer short-term debt to avoid moral hazard problems that result from poor quality firms trying to mimic them if transaction costs are not high enough. Poor quality firms issue long-term debt because they may not be able to roll over short-term debt if information about their low quality investment project is disclosed. If they are unable to refinance short-term debt at maturity, they face sub-optimal liquidation.
We analyze the choice of debt maturity for municipal bonds. Municipal bonds provide an interesting market to analyze the debt maturity decision because they are tax-exempt, free of cash flow restrictions, and not prejudiced by particular types of asset selections. The municipal bond market provides a natural laboratory where the friction of the underlying asset and its volatility are reduced or absent, allowing for better interpretation of the role of contract terms and issuer characteristics on the debt maturity decision.
Several additional factors make the municipal bond market attractive in investigating the debt maturity decision. First, municipalities are semi-sovereign. That is, they may not go bankrupt or even if they go bankrupt, they do not undergo liquidation or any change in ownership. Corporations could face liquidity problems when the debt matures, hence they face sub-optimal liquidation. In contrast, municipal default is rare and even in these cases, recovery rates have been significantly higher relative to corporations. Even in bankruptcy, courts are not empowered to impair the municipality’s ability to collect tax or issue securities.
Second, the widespread debt agency problem in the corporate sector is far less prevalent in the municipal sector. Actions relating to debt issuance could be influenced more by considerations such as patronage (Vijayakumar, 1995) or corruption (Butler, Fauver, and Mortal, 2008). Such issues as underinvestment or excessive risk-taking seen in the corporate sector are largely absent in the municipal sector. Investments are based on community service needs and not on profit. If there is greater growth opportunity, corporations reduce debt maturity to minimize debt agency problems. However, municipalities reduce debt maturity to lower financing costs. Third, corporations strive to achieve some optimal debt ratios and aim for an optimal capital structure. A municipality’s level of debt is influenced by its expenditures on community programs and needs, voter approval, borrowing costs, and legal considerations that could impose debt ceilings. Officials, therefore, have to carefully balance the costs and benefits of increased debt.
Fourth, there is less information asymmetry in local government decisions relative to corporations. Eliminating information asymmetry in relation to bond issuance decisions is difficult. However, information asymmetries at local government levels are significantly lower because decisions are made after open public debates and local council approval. While a general uncertainty about project performance exists, the insider-outsider dichotomy surrounding information access that is prevalent in the corporate sector is not observed in the municipal sector.
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