Biased Expectations and Credit Risk in the Municipal Bond Market

We show that the pricing of credit risk in the municipal bond market depends on the salience of its underlying cash-flow shocks. We find that public mass shootings raise borrowing costs of issuers in affected counties by an average of 6 (5.2) basis points in the secondary (primary) market. This increase in tax-adjusted yield spreads is not driven by any material change in the issuers’ fundamentals, nor by an increase in liquidity risk, risk aversion, or excess debt supply. In contrast, we find no evidence of the violent crime rate in the county being a priced risk factor. The evidence supports an explanation based on biased expectations of fundamentals growth brought about by media driven salience.