The municipal bond valuation puzzle : evidence from U.S. States

Abstract

This paper seeks to elucidate the mechanisms that generate Jiang et al. (2020)'s "government debt valuation puzzle" by adapting their approach to the setting of state-level municipal debt. The main motivation in doing so is that states do not issue their own currencies, and are therefore precluded from monetizing the value of their debt through inflation. I find that, contrary to Jiang et al. (2020), the market value of out- standing state-level government debt is typically smaller than the present discounted value of current and future primary surpluses. For example, the gap between these two quantities is equal to 86.61 percent of GDP for the state of California from 1979 to 2019. This gap may be attributed to a number of factors: (i) expectations of federal bailouts and transfers during recessionary periods; (ii) balanced-budget amendments (BBAs) and statutory debt limits that constrain countercyclical fiscal spending; and (iii) mismeasurement of surpluses due to the omission of state-contingent liabilities for underfunded pensions and insolvent local governments.