Fooling the market? Municipal yields and unfunded state pension liabilities

Existing empirical evidence at the country level exhibits a positive relationship between public indebtedness and the yield on the public debt. Using panel data over the period 2001 – 2014, we show that this relationship holds also for municipal bond yields and the indebtedness of U.S. states. Equally important, we find that municipal bond yields are positively related to implicit state debt, as captured by the financial situation of the states’ civil servants pension funds, which are supposed to be guaranteed by the state government. In fact, the yield effect of an extra dollar of unfunded pension liabilities is of a similar magnitude as that of an extra dollar of explicit debt. The interest rate effects of higher explicit and higher implicit debt are mainly concentrated in the period since the start of the crisis.