In: Economics
Meredith Whitney came out during the Great Recession and stated that there would be billions of dollars in municipalities defaulting on their debt from a lack of tax revenues and too much of a debt burden. Graphically show using the bond market what would happen to the premium between Munis and Treasuries following this announcement.
In each graph, D0 and S0 are initial bond demand and supply curves, intersecting at point A with initial price P0 and quantity of bonds Q0.
When municipalities are expected to default, muni-bonds become riskier. Demand for Muni-bonds decreases, which shifts muni-bond demand curve to left, decreasing both price and quantity of muni-bonds. As bond price and interest rate are inversely related, lower muni-bond price increases muni-bond interest rate.
In following graph, as D0 shifts left to D1, it intersects S0 at point B with lower price P1 and lower quantity Q1.
At the same time, lower demand for muni-bond increases the demand for treasury bonds, its substitute, which shifts T-bond demand curve to right, increasing both price and quantity of T-bonds. As bond price and interest rate are inversely related, higher T-bond price decreases T-bond interest rate.
In following graph, as D0 shifts right to D1, it intersects S0 at point B with higher price P1 and higher quantity Q1.
Higher muni-bond interest rate and lower T-bond interest rate will increase the premium between Muni and Treasury bonds.