Market Discipline or Market Inefficiency? Municipal Bond Spreads, Race,and the Cost of Capital

This paper examines whether municipal bond credit spreads in the United States reflect efficient market discipline or systematic pricing inefficiencies related to issuer racial composition. Using a panel of approximately 145,000 tax-exempt municipal bond issues from 2010–2023, we estimate spread regressions with extensive controls for credit ratings, fiscal fundamentals, bond structure, and macro conditions. We decompose observed spreads into components attributable to credit risk, liquidity, and residual premiums. Across specifications, predominantly Black jurisdictions pay significantly higher credit spreads—15–30 basis points—than otherwise similar non-Black jurisdictions. Decompositions show that only a minority of this premium reflects credit quality or liquidity; the remainder is an unexplained "racial premium." We further show that spreads fail to price physical climate risk while consistently pricing issuer race, contradicting the market discipline hypothesis. The results point to persistent, economically meaningful market inefficiency in public debt pricing with direct implications for financial intermediaries and regulatory policy.