Association for Public Policy Analysis & Management

Traditional finance theory holds that an asset’s price reflects the present value of its future cash flows, and nothing more. In other words, past prices don’t matter. And yet, recent findings in the corporate finance literature suggest precisely the opposite. Current prices of key financial assets like corporate bonds and real estate are often tethered to their trading histories.

Behavioral economists attribute this pattern to a psychological bias known as “anchoring,” or the tendency for decision-makers to overweight the value of past information on current conditions. Sometimes that bias is so strong that investors largely ignore newer, more price-relevant information. Anchoring appears to be a powerful but largely unknown influence on investor decision-making.

In this paper we test for evidence of anchoring in the municipal bond market. In concept, the municipal bond market is ripe for anchoring. It’s an over-the-counter market, and more than 50,000 unique entities have bonds in the market. In such a large and fragmented market investors struggle to acquire price-relevant information, especially since financial disclosures for many governments are unregulated and arrive an average of 10 months after fiscal year close. In this market investors have a strong incentive, and often no other choice but, to rely on past prices for current transactions.

To test for anchoring in the municipal bond market we examine data on more than 20,000 unlimited general obligation bond issues from “repeat issuers.” In this case repeat issuer means an issuer sold similar bonds at least one year apart. We estimate a model, borrowed from recent work on corporate bonds, that identifies how much current prices ought to deviate from past prices given market conditions, and how much they actually deviate. The results suggest that when market interest rates fall, municipal bonds remain tethered to their past prices, so interest rates on municipal bonds do not fall as much as expected. The net effect is that many municipal bond issuers pay much higher cost of capital than what market conditions imply. We attempt to quantify these effects.