Do Municipal Bond Prices Reflect Internal Control Quality?
55 Pages Posted: 1 May 2016 Last revised: 24 Aug 2023
Date Written: May 22, 2023
Abstract
We examine whether internal control problems are priced in municipal bond markets. Government sector internal control problems are frequent, slow to be corrected, and increase the probability of future restatements, fraud, and waste of public resources. Using a generalized staggered difference-in-differences design, primary findings are that municipal bond prices are an economically substantial 5 – 28 basis points higher during years when municipalities have a material weakness in internal controls. Prices are not significantly different during years when governments have significant deficiencies, suggesting the bond market does not differentiate more minor accounting problems. Findings are magnified under circumstances of greater information uncertainty, such as for revenue bond issuances and delayed release of financial information. Additional analysis suggests findings are primarily driven by retail investor trades. Moreover, bonds issued by governments with material weaknesses remain in underwriter inventory significantly longer before eventual sale to investors. Overall, our evidence has two primary implications: first, municipal bond prices reflect compensation to underwriters for the additional inventory holding risk and effort involved in placing bonds issued by municipalities with serious internal control problems; second, dealers may take advantage of retail investors by placing riskier bonds with them.
Keywords: municipal bonds; markups; internal controls; material weakness; entropy balancing; cbps
JEL Classification: G38, H79, K22, M41, M45
Suggested Citation: Suggested Citation