10-05-2026
Bob & Sharon Schafer Chair in Finance Huseyin Gulen, head of the Finance Department at the Daniels School, is timely in his research on the U.S. municipal bond market. This $4 trillion market is a capital markets success story, providing low-cost access to capital for states, cities and towns as well as a tax-efficient, reliable, fixed-income solution to individual investors and some institutions.
The “Fragility Tax” title of Professor Gulen’s paper picks up on the difference between how investors may behave when investing in a bond fund versus owning bonds directly. Funds offer diversification and simplicity, but they lack the key fixed-income qualities of owning individual bonds directly.
Investors in bond funds are shareholders in a pool of bonds that never mature. That characteristic could change investors’ tolerance for market downdrafts and, even if not, leave them somewhat at the mercy of how their fellow shareholders behave. There’s a well-known adage when it comes to fund managers meeting redemption requests — they sell what they can, then they sell what they must. To be fair, that overly dramatizes the reality of regular market liquidity. Municipal bonds are T+1, meaning the trade must settle one day after the transaction date, and enjoy reliable liquidity, reflecting broad demand and the high-quality profile of the market. Furthermore, fund managers have institutional purchasing power, which serves them on both sides of the market.
To further understand the paper’s research, it’s helpful to consider the relevant observations from a practitioner’s vantage point, including how local governments access the market in the first place and how the secondary market is evolving to meet investors’ preferences.
Underwriting desks understand the value of broad and diverse distribution in providing best execution for their public finance banking clients (issuers). In the primary market, municipal bonds are sold publicly either through a competitive sale, where an entire loan structured as bonds is sold to the highest bidder — the one offering the lowest interest rate — or through negotiation, where a retained investment bank structures and sells the loan as bonds through negotiation with prospective buyers.
Bond funds tend to favor negotiated new-issue bond deals. They tend to be bigger, and they offer an opportunity to buy larger blocks of bonds and, through negotiation, influence how they are structured. Larger blocks are generally more liquid than odd lots, but they are also easier to manage in a big portfolio – there are fewer line items of holdings. Negotiated deals can also be a little cheaper, meaning higher yielding, reflecting the discount needed to place a large supply of bonds.
Most deals sell competitively, and aside from the underwriter, the borrower is oblivious and generally agnostic to who ends up with the bonds. Given the complexity of larger bond issues, the greatest dollar value of new issue bonds is sold via negotiation, where the issuer retains an investment bank to underwrite and distribute the bonds. Practically speaking, this is the only approach where a borrower could have some input into who ends up with the bonds. Many bond issuers, for example, give preferred allocation to individual investors. In any scenario, both the borrower and the underwriter are obligated to sell the bonds to whichever investor delivers the lowest net interest cost.
The municipal bond market is notably driven by supply and demand. Once a new bond issue is digested by the market, the likelihood of municipal bonds trading again in the secondary market goes down. This helps offset the fragility tax by starving the market of the issuers’ bonds. Of course, big states and cities that are in the market frequently are less likely to enjoy this premium. New-bond-issue supply and investor demand can both be seasonal and inconsistent, impacting liquidity and borrowing costs for issuers.
Importantly, the availability of professionally managed municipal bond portfolios is advancing with alternatives to funds. To meet investors’ preference for owning bonds directly, there has been considerable growth in professionally managed separate accounts or “SMAs.” This may be a benefit to the primary market for bond issuers as it aggregates individual investor demand across the yield curve.
The growing influence of SMAs can influence the secondary market as well. Professional managers of SMAs are likely more in touch with bond issuer reporting, changing credit and market fluctuations than most retail investors. This underscores the case for issuers to know their investor base. The authors recommend smart steps for issuers, centered around better understanding and cultivating a diverse investor base. There are turnkey platforms available for issuers to help with this.
Bond structure and investor composition can shape outcomes in the municipal bond market. For bond issuers, understanding demand dynamics, tax sensitivity and distribution channels, particularly the growing role of SMAs, may help lower borrowing costs and solve the question of releasing bonds as negotiated or competitive. For investors and advisors, the central concerns are the trade-offs between bonds owned by mutual funds versus direct ownership, especially in a market where liquidity and tax considerations are often deciding factors.
Tim Coffin is a Daniels School Business Fellow and was most recently a director at Breckinridge Capital Advisors. He speaks regularly at conferences on topics related to sustainable investing and finance.
