Liquidity Considerations in Municipal Bonds
Municipal bonds trade in a fundamentally different market than Treasuries or corporates. With over 1 million CUSIPs from 50,000 distinct issuers, the municipal market is extraordinarily fragmented (Harris & Piwowar, 2006). The point is: the same bond that traded easily at $100,000 may prove nearly impossible to sell at $25,000 without significant price concession.
Why Municipal Liquidity Differs (The Structural Reality)
The municipal market's structure creates persistent liquidity challenges that equity investors rarely encounter. Understanding these mechanics prevents costly surprises when you need to exit.
The buy-and-hold problem: Roughly two-thirds of municipal bonds are held by retail investors and buy-and-hold institutions that rarely trade. Many individual CUSIPs go months or years between trades. When you own a bond that simply doesn't trade, price discovery becomes guesswork.
The fragmentation issue: Unlike Treasuries (where a handful of benchmark issues dominate volume), municipal issuance is scattered across thousands of small issuers. A $5 million school district bond in rural Ohio has no natural secondary market beyond the dealer who underwrote it.
The durable lesson: Municipal liquidity isn't just about market conditions—it's baked into the asset class's structure.
Bid-Ask Spreads: The Hidden Cost of Trading
Bid-ask spreads measure what you pay to enter and exit positions. In municipals, these spreads vary dramatically based on trade size and bond characteristics.
Mean spreads by market segment (MSRB, 2024):
- Municipal bonds: 23 cents per $100 par value
- Corporate bonds: 21 cents per $100 par value
- Treasury bonds: 8 cents per $100 par value
The spread difference looks small—but it compounds. A 23-cent spread on a municipal versus 8 cents on a Treasury means 15 cents per $100 of additional round-trip cost. On a $500,000 position, that's $750 in extra transaction costs. Research confirms municipal transaction costs substantially exceed those in other fixed income markets (Green, Hollifield & Schurhoff, 2007).
Why this matters: For active traders, these costs erode returns. For buy-and-hold investors, the entry cost matters less—but the exit cost becomes critical if circumstances force a sale.
Retail vs. Institutional Pricing (The Size Penalty)
The municipal market punishes small trades. Institutional investors trading in $1 million+ blocks typically pay spreads under 50 cents per $100. Retail investors trading odd-lots face a different reality entirely.
Retail trade spreads range from 25 cents to $4 per $100 for odd-lots (MSRB, 2024). The variance is enormous. A $25,000 retail trade might cost 8x more per dollar than an institutional block.
The mechanics: Dealers face fixed costs in processing any trade—compliance, settlement, inventory risk. Spreading those costs over a $50,000 trade versus a $5 million trade yields radically different per-dollar economics.
The math example:
- Institutional trade: $1,000,000 x 0.40% spread = $4,000 cost
- Retail trade: $25,000 x 2.50% spread = $625 cost
The institutional investor paid $4 per $1,000 of bonds. The retail investor paid $25 per $1,000—more than six times the cost per dollar invested.
The test: Small position → Higher per-unit spread → Disproportionate transaction cost drag
Market Improvements (But Still Behind Other Fixed Income)
The municipal market has improved significantly since the pre-crisis era, driven by electronic trading platforms and regulatory transparency.
Effective spreads declined approximately 77 basis points from 2005 to 2018 (SIFMA, 2024). Retail-sized trades saw even larger improvement—approximately 96 basis points of spread compression over the same period.
What changed:
- EMMA transparency: Real-time trade reporting since 2005 lets investors see recent prices before trading
- Electronic platforms: Alternative trading systems now handle significant municipal volume
- Competition: More dealers and platforms competing for flow
What hasn't changed: The underlying fragmentation. You still can't short municipal bonds (eliminating a key liquidity mechanism). Most CUSIPs still trade infrequently. Odd-lot penalties persist.
Detection Signals: You're Likely Exposed If...
- Your municipal position is under $100,000 in a single CUSIP (odd-lot territory)
- The bond last traded more than 90 days ago (check EMMA for trade history)
- You own bonds from issuers with less than $100 million total debt outstanding
- Your portfolio includes unrated or single-rating securities
- You're counting on selling during a market stress event (spreads widen when you most need to exit)
The COVID-19 Stress Test (What March 2020 Revealed)
The March 2020 market disruption exposed municipal liquidity fragility. When investors rushed for exits, the market strained.
The Municipal Liquidity Facility (MLF) lowered yields by approximately 72 basis points (Federal Reserve, 2020). The mere announcement of federal backstop improved conditions—even before significant purchases occurred.
ETF discounts revealed the gap: The iShares National Muni Bond ETF (MUB) traded at a 576 basis point discount to NAV during peak stress (BlackRock, 2020). Investors selling ETF shares received far less than the underlying bonds were theoretically worth.
The lesson: Municipal liquidity is pro-cyclical. When you most want to sell (market stress), liquidity evaporates. When markets are calm, liquidity appears adequate—creating false confidence.
Why this matters: Liquidity planning must assume stress conditions, not normal conditions.
Strategies for Managing Municipal Liquidity Risk
Ladder to Reduce Forced Sales
A bond ladder—holding bonds maturing across multiple years—ensures you have natural liquidity (maturing bonds) rather than depending on secondary market sales. If you need cash and your 2026 maturity is approaching, you avoid selling into an illiquid market.
Size Positions for Exit
Before buying a $50,000 position, ask: can I sell this without excessive spread if needed? Consider concentrating in larger positions of fewer CUSIPs rather than small positions across many bonds.
Use ETFs and SMAs for Smaller Allocations
For allocations under $250,000, the transaction cost math often favors ETFs or separately managed accounts (SMAs) over individual bonds. Professional managers trade in institutional size, passing along better execution to smaller investors.
SMA assets grew from $778 billion in 2013 to $2.2 trillion in 2023 (Cerulli Associates, 2024). The shift reflects recognition of liquidity advantages in managed vehicles.
Check EMMA Before Trading
The EMMA system provides free access to recent trade prices. Before accepting a dealer quote, verify recent transaction prices for comparable bonds. A bond that traded at $102 last week shouldn't be quoted at $98 today without explanation.
Checklist: Managing Municipal Liquidity
Essential (Start Here)
- Verify trade history on EMMA before buying any municipal position
- Size positions above $100,000 when possible to avoid odd-lot penalties
- Maintain a bond ladder to ensure natural liquidity through maturities
- Avoid concentrated positions in small or obscure issuers
High-Impact Refinements
- Compare dealer quotes to recent EMMA trade prices before executing
- Consider ETFs or SMAs for allocations under $250,000
- Stress-test your liquidity needs—assume spreads widen 2-3x during market stress
The Fund vs. Individual Bond Trade-Off
Individual bonds offer certainty of cash flows and control over tax-loss harvesting. But they carry meaningful liquidity risk for smaller investors.
The common mistake: Investors chase slightly higher yields on individual bonds, ignoring that the spread to sell may exceed the yield advantage they captured.
The calculation that matters:
If a municipal fund charges 0.20% annual expense but saves 0.50% on transaction costs versus self-directed trading, the fund wins. The yield difference visible on your screen often misleads—net-of-transaction returns tell the real story.
Over $1 billion in collective savings could have been realized in 2019 alone if retail muni investors had used index funds instead of picking individual bonds (Schwab, 2024). The "savings" came primarily from avoiding adverse selection and spread costs.
Your Next Step
Before your next municipal bond purchase, check EMMA for the bond's recent trade history. If the bond hasn't traded in 60+ days, or only trades in small sizes, price your expected exit cost—not just your entry price. That exit cost is real money.
Related: Using SMAs vs. ETFs for Municipal Exposure | Credit Analysis for State vs. Local Issuers | Disclosure Requirements and EMMA Filings
Sources: EMMA - Electronic Municipal Market Access (2024). Trade Data and Disclosure Repository. | MSRB (2024). Market Transparency Research. | SIFMA (2024). U.S. Municipal Bonds Statistics. | Federal Reserve (2020). Municipal Liquidity Facility Impact Analysis. | Cerulli Associates (2024). Separately Managed Account Market Trends.