Municipal bond yields are higher in states that are allowed to final for Chapter 9 bankruptcy

Source: Pengjie Gao, Chang Lee, Dermot Murphy, Chang Lee, University of Notre Dame and University of Illinois at Chicago, This Draft: March 15, 2016, paper presented at the presented at the 5th Annual Municipal Finance Conference, 2016

Policies on financially distressed municipalities differ significantly across US states, with some states allowing municipalities to file for Chapter 9 bankruptcy (“Chapter 9 states”), while others have strong policies in place to deal with distressed municipalities via state assistance programs (“Proactive states”). A new paper from Pengjie Gao at the University of Notre Dame and Chang Lee and Dermot Murphy at the University of Illinois at Chicago finds that such policy differences significantly affect local municipal borrowing costs. Local municipal bond yields in Chapter 9 states are higher and more cyclical than those in Proactive states. Moreover, following a default event in Chapter 9 states, the average yield of defaulted bonds increases more than those in Proactive states. Default events have a contagion effect among no-default bonds in Chapter 9 states, but not in Proactive states. Lower borrowing costs for local governments come at the expense of higher borrowing costs for the state government through a channel of counter-cyclical intergovernmental transfer. Proactive states bear more local credit risk than Chapter 9 states and as a result, their yields on state-issued general obligation bonds are higher.