Two essays in municipal bonds risk

State and local governments rely primarily on defined benefit pension plans to provide pension benefits for their employees, and since these types of plans are unfunded by nature, state and local governments in the United States have accumulated large sums of unfunded liabilities estimated at close to 375 billion dollars. These sums, if they continue to increase, will lead to future financial stress for state and local governments and could undermine their ability to borrow in order to fund their current and future capital expenditures.;This issue is addressed in this dissertation in two related essays, the first essay is theoretical and the second one is empirical. The first essay, which is contained in the second chapter, addresses the effect of unfunded liabilities by introducing a simple two-dates-two-types stochastic model where municipalities borrow in the first period and repay their debt in the second one. In this model, municipality's manager has to choose between two signals. The first signal is to borrow an amount to fund a project plus an amount to fully fund the municipality's pension plan and the second signal is to borrow an amount to fund only the project. Then, by tying the manager's utility to the municipality's future performance, I am able to find a separating equilibrium where each manager's expected utility is higher if he signals his municipality's type truthfully.;The second essay, presented in the third chapter, addresses the empirical effect of unfunded liabilities on municipal bond risk. I investigated the relationship between the unfunded liabilities of public pension plans and Moody's credit ratings for the municipalities located in Massachusetts and found a negative relationship. Specifically, the higher the unfunded liabilities are, the lower the municipal credit ratings. This relationship has an important implication for municipal finance in balancing the increase in the unfunded liabilities with the increase in the cost of debt that results from lowering the municipality's credit ratings.