The right and wrong models for evaluating callable municipal bonds

Peter Orr, David de la Nuez

ABSTRACT
Fixed rate municipal bonds are often sold with an optional redemption feature giving
issuers the right to call the bonds prior to maturity. The application of no-arbitrage bond
option models to help assess the value of these optional redemption features though not
common has been increasing. Despite the availability of these models, widespread public
finance industry adoption has not occurred. This paper outlines theoretical and practical
problems with no-arbitrage models employed for the purpose of analyzing embedded
options in municipal bonds. We also highlight recent research in yield curve modeling
and show an example of a real-world approach to analyzing municipal bond options
which introduces the concept of expected present value (EPV) savings.

1. Introduction
Of the $3.7 trillion in municipal and tax-exempt bonds outstanding1, approximately $1.54
trillion2, or 41.6%, are long-term, fixed-rate, unrefunded and subject to redemption prior to maturity at the
option of the issuer. These optional redemption features are call options purchased by the issuer at the
inception of a bond transaction. Issuers usually fund an optional redemption through a refinancing issue
called a refunding. Per current tax code3 there are two types of refundings, current and advance. The latter
occur more than 90 days in advance of the call date and involves using proceeds from the refunding issue
to purchase a portfolio of eligible securities (State and Local Government Securities (SLGS), US
Treasuries or agency securities) designed to match the cash flows of the refunded bonds to their
respective first optional redemption dates.4,5
A stubbornly intractable problem faced by practitioners yet addressed infrequently by researchers
relates to determining the optimal timing of exercise (e.g. see (Gurwitz, Knez, & Wadhwani, 1992),
(Kalotay, Yang, & Fabozzi, 2007), and recently (Ang, Green, & Xing, 2013)). For American and
Bermudan options, the definition of an optimal exercise strategy is synonymous with valuation; without a
clearly defined optimal exercise, there can be no correct option valuation. (Glasserman, 2003) states,
The value of an American option is the value achieved by exercising optimally. Finding
this value entails finding the optimal exercise rule by solving an optimal stopping
problem and computing the expected discounted payoff of the option under this rule.
So how do issuers in practice solve this optimal stopping problem? How do they select when to
refund bonds? Many issuers use long-standing heuristics to determine whether or not to refund a bond
1

Source: Report on the Municipal Securities Market, U.S. Securities and Exchange Commission
Source: Bloomberg, August, 2013
3
Section 148 of the Internal Revenue Code covers rules governing tax-exempt bond issuance including refundings.
4
For a detailed description of refunding mechanics see Ang , , (2013) and Kalotay (1998)
5
There is disagreement as to whether the ability to advance refund a bond enhances or detracts value from the issuer.
Ang et al (2013) maintains, Advance Refunding provides short-term budget relief, but it destroys value to the
issuer. By pre-committing to call, the issuer surrenders the option not to call should interest rates rise before the call
date. Kalotay (1998) on the other hand characterizes this differently saying, The advance refunding option (ARO)
is intimately tied to the call option. In the absence of a call option, the ARO has no economic value. An advance
refunding locks in the call exercise an issue that is advance refunded will be called at the first call date (at the
previously set call price). The value of the ARO should therefore be measured incrementally above that of the call
option.
2

such as present value interest cost savings (PV savings) as a percentage of the par amount of the refunded
bonds. Once this percentage exceeds a specified threshold, usually between 2 and 6%, the bonds are
deemed to be candidates to include in a refunding bond issue.
But American and Bermudan bond call options are one of the most common forms of exotic
interest rate derivative (see (Rebonato, 2003)).6 And a variety of term structure models are readily
available commercially that are suitable for pricing these options. Why has there not been widespread
application of these technologies to the municipal market?
Though some may point to a dearth of Street quants engaged in addressing problems in public
finance, another plausible reason is that term structure and bond option models designed for relative
pricing in arbitrage-free environments do not apply. Perhaps they are round pegs that do not fill neatly
into the square holes of embedded municipal bond options. In the remainder of this paper we address this
possibility. We first describe two broad classes of users of term structure models, hedgers and speculators,
with an example highlighting terminology and more importantly modeling approaches applicable to each.
We next provide a brief taxonomy of term structure models with a discussion of their purposes and
features, followed by a discussion of municipal bond options, their characteristics, and the best term
structure models to use in their analysis and valuation. Last we apply a regime-switching yield curve
model derived from recent research which sheds important new light on how to evaluate these features
include the concept of expected present value (EPV) savings.
2. Hedgers, Speculators and the Terminology of Models
For the purpose of analyzing term structure models the world is split into two types of market
participants: hedgers and speculators. Sometimes these players go by other names: sell-side and buy-side
or dealers and end-users. For our purposes the characteristics are the same: speculators are those that take
and manage naked long or short positions, while hedgers are those that are also exposed to risks but
6

Some may treat American options as a vanilla product but as a practical matter, determining the optimal exercise
strategy for American or Bermudan bond options involves solving the same free-boundary problem. For this reason
we refer to both of them as exotic here.

attempt to apply offsetting positions that lead to (ideally) a net zero risk exposure. The canonical example
of a hedger is a sell-side dealer.
Though the term speculator tends to carry a loaded and pejorative meaning in public finance
circles (state and local laws abound prohibiting what is defined as speculation), for purposes of evaluating
term structure models both issuers and investors fall into exactly this camp: they each hold naked,
unhedged risk positions, short and long bonds, respectively. In the fixed income context speculators or the
buy-side are fixed income mutual funds or hedge funds, pension funds, insurance companies,
commercial banks, corporate borrowers, municipal borrowers, and others. (Rebonato & Nawalkha,
2011)
Functionally, hedgers are concerned with the right price for instruments. Dealers attempt to make
prices that are consistent with other traded instruments in the market. If inconsistency exists, then
arbitrage profits may follow. However, the theory that takes this idea and extends it to an ability to price
assets generally7 relies fundamentally on two market characteristics: completeness and efficiency. This
approach can be shown equivalent to one where the price of any asset under these conditions is the
discounted expectation of the assets payoff under what is referred to as the risk-neutral measure. The
counterintuitive discount rate to be used in all such cases, irrespective of the riskiness of the underling
instruments, is the risk-free rate (see example below). This approach, relying heavily on measure theory,
has led to a new lexicon in asset pricing. In the literature one now finds reference to risk-neutral
pricing, the risk-neutral density, risk-neutral valuation, the risk-neutral world, and risk-neutral
inputs. All are different ways in which to describe the requisite arbitrage-free environment.
Speculators, on the other hand, are concerned with price but are also very interested in value.
Valuation may be driven by a host of real world considerations that may involve economic or financial
forecasts, holding periods, and other unique needs or circumstances that drive the assessment of costs or

The most recent and general incarnation of this theory can be found in (Delbaen & Schachermayer, 1994).

benefits relative to a specific risk. The modeling world for this type of arbitrage-rich valuation setting has
its own nomenclature in contrast to the risk-neutral terminology above; the speculators domain is
variously called the real, physical or objective world or measure. Note that if arbitrage exists, the
only recourse is to analyze assets in this real or physical world environment.
3. Risk-Neutral versus Real Worlds An Example
To illustrate the distinction between risk-neutral and real or physical worlds, we take a
simple numerical example from the equity markets. Start with technology stock ABC currently trading at
price SABC = 100. You are asked to make a price for purchase of non-dividend stock ABC on a forward
basis in one year i.e. to offer a forward contract on ABC at price FABC. The consensus annual return on
equity (ROE) forecast for ABC is 35% and the one year risk-free rate of interest is Rrisk-free = 5%. At what
price do you set your forward contract on ABC? Given the consensus forecast, you might think the
appropriate forward price on ABC is
FABC = (1+ROE) SABC = (1+.35) 100 = 135.
However, other market participants could then borrow 100 at 5% to purchase the stock today.
Next year they would take the 135 forward price you pay them, pay back the loan plus interest (105 total),
deliver the stock they purchased today, and pocket 30 per share. Ignoring delivery risks, this transaction
generates riskless profits.
Clearly 135 is not the correct price if arbitrage profits are to be precluded. In order to set the
arbitrage-free price you must determine the risk-free trading strategy that replicates the terms of the ABC
forward contract. You are obligated to purchase ABC stock in one year though in the end you do not want
to own it. If you sell a share of ABC stock short today for $100, invest the proceeds at the risk-free rate,
in one year you will have 105 plus a short sale of ABC stock that needs to be covered. This self-financing
trading strategy generates both cash and the requisite short position in ABC stock to immunize the overall
position. Therefore the arbitrage-free price of the forward contract is in fact 105. Our implicit assumption
is that ABC grows at the risk-free rate of interest,
4

FABC = (1+Rrisk-free) SABC = (1+.05) 100 = 105.

In this example we presumed ABC was a technology stock with a consensus ROE of 35%. What
if it were a utility stock with an expected ROE of 12%? Or a bank stock with an expected return of 17%?
Where did the real world assumption for the growth in ABC enter our calculation of the forward price? Of
course it did not. Given our trading strategy ignores the real world returns entirely, we say this is a riskneutral trading strategy; the underlying riskiness of the assets in question is completely irrelevant. A
trader at a dealer bank making prices on these types of forwards is concerned solely about the cost of
financing the position. We can assume, irrespective of the real-world growth of the underlying asset, that
it grows at the risk-free rate.
On the other hand, for an investor who wants to buy or sell this forward contract in an unhedged
environment, the real-world return on the stock very much matters. It is the real-world return that
ultimately drives the payoff and that is the environment in which she performs her analysis.
4. Types of Term Structure Models and their Roles
Though a variety of excellent surveys and taxonomies of term structure models already exist (e.g.
see (Brigo & Mercurio, 2001), (Rebonato, 2003), (Rebonato & Nyholm, 2008), (Narwalkha, Beliaeva, &
Soto, 2007)), we offer one more in the hopes that it be at once more concise and intuitive for public
finance practitioners then those that have come before, while still managing to serve the technical
purposes of this paper. To this end we divide term structure models into three categories: deterministic;
pricing; and real-world. Those either well-versed in term structure modeling or less interested in such fare
may proceed to Section 5 without loss of overall meaning.
Deterministic
It could easily be argued that deterministic models do not belong in the category of term structure
models at all. However, we think it important to point out that deterministic models are the most common
yield curve models used in public finance today. Deterministic models are a special case of a more

complete term structure model i.e. they simply display zero volatility. As an example, in order to create a
forecasted schedule of principal and interest for variable rate demand obligations (VRDOs), a public
finance analyst must employ an interest rate model, usually of the deterministic variety. The rate selected
is often constant and is frequently a simple historic average of short-term yields over some period.
Pricing Models
Pricing models, or as they are frequently called relative pricing models, are designed to do just
that: price interest rate derivatives using an over-arching assumption that markets are arbitrage-free. In
order to price an instrument such as a bond option, these models rely on the ability of the user to eliminate
the risk involved in being short or long such an instrument, just as described in our simple forward stock
example above. In order for a pricing model to become successful or perhaps even a market standard, it
must balance certain competing objectives,
Some of the prerequisites for industry acceptance are ease, quickness and stability of
calibration, speed of pricing for reallive quotes and for hedging, ability to give an
intuitive interpretation to the model parameters, market consensus about the modelling
approach, etc. Not surprisingly, it is rare for a theoretically justifiable model to display
all, most, or even a few of these features. (Rebonato & Nawalkha, 2011)
And further,
unless the model allows fast and stable calibration it cannot be used for industry purposes, no
matter how attractive. (Rebonato & Nawalkha, 2011)
Pricing models are founded on the dual principles of market completeness and efficiency i.e. all
derivative payoffs are replicable with other usually more basic instruments and there are no free lunches.8
(Rebonato, 2003) further subdivides relative pricing models into two camps: fundamental models that
explicitly estimate the functional form of the market price of risk along with the true dynamics of yield
curve and reduced form models that evolve yields directly in a risk-neutral setting. Early examples of
fundamental models include (Vaek, 1977), (Brennan & Schwartz, 1982), (Cox, Ingersoll, & Ross,
1985), and (Longstaff & Schwartz, 1992).
8

(Rebonato & Nawalkha, 2011) go so far as to say Complexderivatives models are technological tools mainly
used to price and hedge structured products.

In reduced form models, forward rates and implied volatilities from the current prices of vanilla
swaps, caps, and swaptions are used to calibrate the model directly and ultimately evolve the yield curve
only in the risk-neutral world. Examples of reduced form relative pricing models include (Ho & Lee,
1986), (Hull & White, 1990), (Black, Derman, & Toy, 1990), (Black & Karasinski, 1992), and (Brace &
Musiela, 1997) and (Jamshidian, 1997). In 1990s the reigning paradigm for derivatives pricing became
the LIBOR market model ( (Brace & Musiela, 1997) & (Jamshidian, 1997)). The most salient feature was
its ability to recover the log-normal (Black) prices of caplets and swaptions (de Guillaume, Rebonato, &
Pogudin, 2013). Currently, a variation on the LIBOR Market Model, the LMM-SABR model is
considered by many to be the gold standard in relative pricing models (Nawalkha, 2009).
Real World Models
Real world yield curve models have shown perhaps the most development over the course of the
last decade. These models are designed for the purpose of creating yield curve evolutions in the real world
measure, in contrast to risk-neutral ones described above in pricing models. Emphasis for these models is
not on calculation speed or calibration ease but rather on capturing the driving econometric and statistical
features observed in actual yield curves. Sample applications for this class of term structure model
include:

asset and liability management for corporations, banks and pension funds;
strategic asset allocation decisions;
counterparty credit risk assessment;
testing the effectiveness of derivatives pricing models. (Rebonato & Nyholm, 2008)

One of the earliest types of real world rate models developed involves Principal Component
Analysis (PCA) (see (Martellini & Priaulet, 2001) for a review). The PCA method involves transforming
historic yield curve changes into principal components, a small number of which often explain the vast
majority of historic yield curve movements. The first three principal components also offer an intuitive
interpretation respectively level, slope and curvature. Unfortunately, simulating yield curves using PCA
can quickly lead to unrealistic yield curve shapes, even if one retains all of the principal components in
the data (see (Rebonato R. , Mahal, Joshi, Bucholz, & Nyholm, 2005)). Other examples of real world
7

yield curve models include VAR modeling (Kugler, 1990) and (Lanne, 2000), VAR and regime switching
(Engsted & Nyholm, 2000), (Rebonato R. , Mahal, Joshi, Bucholz, & Nyholm, 2005), (Bernadell, 2005),
(Diebold, Rudebusch, & Aruoba, 2006) and (Diebold & Li, 2006).
One of the more exciting recent discoveries in real-world yield curve modeling is reflected in (de
Guillaume, Rebonato, & Pogudin, 2013); they find an interest rate modeling missing link which
successfully explains how yield changes relate to yield levels. The relationship holds across currencies
and decades, even centuries, of observed yield curves within a regime switching model that lends itself to
generating history-consistent yield curves. We use this research as a basis for modeled results in Section
8.
5. Pricing Models Fundamental Problems
Given the term structure model taxonomy above, it is clear that deterministic models are ill-suited
for evaluating the call options in municipal bonds: the uncertain degree of opportunity lost from
exercising a bonds redemption feature must be evaluated and this requires modeling and capturing the
stochastic nature of yield curves. Pricing models are the next candidate though it should come as little
surprise that they are not the answer either. We first explain why, ignoring the quirks of the municipal
market while focusing on the purpose and nature of the models themselves.
As discussed above, relative pricing models are designed to determine the price of assets in the
risk-neutral measure. In practice this measure is embodied in a tree, lattice or other simulated
environment. However, in a fixed income setting do yield curves within this risk-neutral world resemble
real, history-consistent yield curves? To the surprise of many, the answer is no. The drift term within
pricing models leads to yield curve behavior that simply has never occurred:
These drift terms, as is perfectly appropriate for the relative-pricing application for
which they have been devised, drive a wedge between the real-world and the riskadjusted evolution of the yield curve. As mentioned above, over long horizons, the
evolutions produced by these approaches become totally dominated by the no-arbitrage
drift term and bear virtually no resemblance to the real-world evolution. (Rebonato R. ,
Mahal, Joshi, Bucholz, & Nyholm, 2005)

Further, in discussing the applicability of pricing models to topics such as the ones mentioned
above,
There is a more fundamental problem with these approaches, that makes them
unsuitable for our purposessince these models have been designed to price derivatives
securities, the modelling choices of the real-world dynamics of the yield curve tend to be
dictated by computational considerations: one-factor models, which imply approximately
parallel moves of the yield curve, for instance, are common and the diffusive assumptions
for the driver(s) is almost universally made. For these reasons, fundamental pricing
models are not appropriate for the [valuation] applications highlighted in Section 1.
(Rebonato & Nyholm, 2008)
And though the section below is in relation to the currently popular Libor Market Model, the
critique applies equally to the analysis of municipal call options with any relative pricing model,
The virtues of the LMMSABR model which allow it to perfectly fit the observed prices
of bondsunder the riskneutral measure, are of not much use to most sophisticated
institutional users of interest rate derivatives and structured products, if these virtues do
not allow a meaningful riskreturn analysis under the physical measureThese
institutions [end-users and municipalities] are not in the business of making money by
trading interest rate derivatives while maintaining zero exposures. This is the major
difference between sellside dealer banks and the buyside borrowers and investors.
Hence, the buyside users of interest rate derivatives need to perform risk return analysis
under the physical measure to understand the risk and return tradeoffs [emphasis
added]. (Rebonato & Nawalkha, 2011)
It is interesting to note that even within the purview of pricing models, there is currently some
debate as to whether or not market-implied (i.e. arbitrage-free) quantities are entirely appropriate. If there
is reason to believe that structural imbalances may exist in markets, and that arbitrage activity may be
curtailed by residual and material risks, then even in a relative pricing context, market-implied values
may not be the best choice (see (Rebonato, 2003)).
6. Pricing Models Problems Specific to the Municipal Market
Though an issuer may exercise an optional redemption for a variety of reasons including retiring
bonds with restrictive covenants, replacing insured bonds, or simply applying excess revenues to shrink
the balance sheet, the most common objective is to achieve interest cost savings through financing with
lower interest rates. This is called a high-to-low refunding. This last motive is the one we focus on here.
Traditional no-arbitrage bond option models rely on the existence of a non-callable underlying
equivalent bond which can be traded in a continuous fashion with unfettered ability to be bought or sold.

In the municipal bond market this situation simply does not exist. (Ang, Bhansali, & Xing, 2010) describe
in some detail the reasons why it is so difficult to hedge a municipal position in the context of market
discount bonds even for dealers, though the analysis applies equally in the broader municipal bond
context to both issuers and investors,
Municipal issuers are unable to arbitrage the mispricing of market discount bonds. IRC 148
specifically prohibits arbitrage across municipal bonds and other types of bonds (for example,
Treasury and corporate bonds) by tax-exempt institutions. Dealers, however, should still view the
taxation of market discount bonds by individuals as a profitable trading opportunity. However, a
major impediment is that dealers have little ability to hedge the purchase of market discount
bonds on their books. Unlike Treasury bonds, shorting municipal bonds is very hard because only
tax-exempt authorities and institutions can pay tax-exempt interest. An investor lending a
municipal bond to a dealer would receive a taxable dividend because that dividend is paid by the
dealer, not a tax-exempt institution. Even if an active repo municipal market existed, it may be
hard to locate a suitable municipal bond as a hedge because of the sheer number of municipal
securities. Shorting related interest rate securities, like Treasuries and corporate bonds, opens up
potentially large basis risk. Another reason arbitrage may be limited is because the trading costs
are much higher than Treasury markets.
We can put a finer head on this if we look at the hedge strategy for a municipal bond option with
an eye towards which ones are traded and observable. For a complete analysis we would need the
following:
(1) Option free tax-exempt yields for the issuer
(2) Implied volatilities for the yields in 1)
(3) Market yield curve for escrow securities (SLGS or other)
(4) Implied volatilities for escrow yields in 3)
(5) Option free taxable yields for the issuer (for callable, non-advance refundable bonds)
(6) Implied volatilities for the taxable yield curve in 5)
(7) Implied correlations between option free tax-exempt yields and escrow yields
(8) Implied correlations between option free taxable yields and escrow yields and,
(9) Implied correlations between tax-exempt and taxable issuer yields
Few of these items are observed directly as traded instruments. SLGS are published at the end of
each trading day on the Treasurys web site. Given that SLGS are designed to be a basis point lower than
comparable US Treasury yields we might imply (4) from the prices of traded Treasury options, though at
present no study exists comparing the two markets or the validity of that assumption. Items (1) and (5) we
might try to estimate using secondary market data and a methodology like one described in (Nelson &
10

Siegel, 1987), though this data is choppy at best and frequently entirely unobservable, particularly for (5).
Volatilities in items (2) and (6) depend upon an active market or accurate option pricing which, as
discussed in this paper, presents an interesting chicken or egg problem. How should one imply volatilities
without market-tested, reliable, trading-based models? Correlations for (7)-(9) simply do not exist on an
implied basis in any market.
We agree with (Kalotay & May, 1998) that in order to completely analyze the municipal
refunding decision, both treasury and borrower yield curves must be understood. However, no-arbitrage
term structure models are ill-equipped for accommodating the dynamics of full yield curves from multiple
markets and the resulting calibration issues that ensue. Given the importance of both the replacement
yield of the new bond, which usually matches closely to the maturity of the refunded bond, and the yield
on the escrow, which is to the call date,9 any single factor model is inadequate for this purpose.10
The logical conclusion of the above analysis is that models designed for relative pricing in
general provide little benefit and are simply inappropriate.
7. Characteristics of a Good Model for Analyzing Municipal Bond Call Features
In order to properly evaluate municipal call options, we find the following characteristics
desirable in a markets model:
1. Positive nominal rates
2. Full description of term structure dynamics including volatilities and correlations for at least
three markets: tax-exempt, taxable, and escrow investments
3. Control over yield curve shapes while allowing for variation of slopes, humps, and twists
4. Recovery of the distributions of historical yield changes
5. Replication of historic yield correlations both within and across markets
6. Long high end and fat low end distribution tails for the yields themselves
7. Accurate analytic approximations of yield distributions
8. Rapid calculation without excessive memory load
9

Note these are not only two different points on the yield curve, but also two entirely different markets.
It doesnt make sense to use a single factor model to value any security whose cashflow is linked to the shape of
the yield curve. (Kalotay A. , 1995)
10

11

With a market model fitting the above criteria we could then analyze and evaluate different
exercise criteria currently in practice as well as ultimately establish refunding criteria to determine
valuation.
8. Real-World Examples Introduction to Expected Present Value (EPV) Savings
We find a model derived from recent research by (de Guillaume, Rebonato, & Pogudin, 2013) to
be a best-fit which, with some enhancements and adjustments, satisfies all eight criteria above.11 We
created 10,000 simulations of three interdependent yield curve markets over 30 years using daily yield
curve data from 1970 to 2013.12 Inputs include a starting yield curve as well as infinite horizon yields
towards which yields will revert over the analytic horizon. The latter are usually derived from a forecast
or long-term average for each tenor in the yield curve over an historical period deemed relevant.
The starting yield curves (solid lines) and their respective infinite horizon yields (dotted lines) are
shown in Figure 1 and Table 1:

11
12

See forthcoming research Evaluating Municipal Refunding Criteria: A Simulation-Based Approach.

SOURCE: Delphis Hanover Corporation

12

7%

6%
5%
4%
3%
2%
1%
0%

TE Infinite Horizon

SLGS Infinite Horizon

Taxable Infinite Horizon

Tax Exempt Spot

SLGS Spot

Taxable Spot

Figure 1
Table 1

Tax Exempt
Tenor
3 Month
6 Month
1 Year
2 Year
3 Year
4 Year
5 Year
7 Year
10 Year
12 Year
15 Year
20 Year
30 Year
40 Year

Spot
0.175%

Infinite
Horizon
2.791%

0.320%
0.450%
0.660%
0.870%
1.020%
1.520%
2.180%
2.640%
3.010%
3.490%
4.030%
4.160%

3.000%
3.450%
3.833%
4.158%
4.434%
4.669%
4.869%
5.038%
5.183%
5.305%
5.409%
5.498%

SLGS

Taxable
Infinite
Horizon
3.158%
3.613%
3.994%
4.315%
4.584%
4.811%
5.001%
5.162%
5.297%
5.410%
5.505%
5.586%
5.653%

Spot
0.071%
0.112%
0.130%
0.240%
0.350%
0.520%
0.750%
1.210%
1.860%
2.130%
2.390%
2.700%
3.090%

13

Spot
0.321%
0.362%
0.432%
0.668%
0.785%
0.855%
1.414%
1.983%
2.731%
3.171%
3.461%
3.762%
4.092%

Infinite
Horizon
3.408%
3.863%
4.296%
4.743%
5.019%
5.146%
5.665%
5.935%
6.168%
6.451%
6.576%
6.648%
6.655%

Fifteen samples of tax-exempt borrower and escrow yield curves are shown in Figure 2 below.
Note that each simulated environment includes a complete set of correlated taxable, tax-exempt, and
escrow yield curves. The colors of tax-exempt and escrow yield curves are matched to their respective
simulated environments and as expected, borrowing and escrow yield curves are consistently high or low
depending on the simulated environment.

Figure 2

14

Though the simulations are performed daily to more faithfully capture real yield curve dynamics,
we calculate the value of refunding certain hypothetical bonds on a quarterly basis using an assumption of
one percent for costs of bond issuance. The net present value (NPV) savings calculation reflects negative
arbitrage13 where it exists and ensures the escrow yield is no greater than the bond yield for tax-exempt
refundings.14 The objective is to create a standard NPV savings value in each simulated environment, akin
to an option payoff. As an example, the graph below shows the distribution of NPV savings for a 5%
bond maturing July 1, 2031 callable July 1, 2016.

Figure 3

The bond in Figure 3 is a bond callable but not eligible for refunding on a tax-exempt basis until
90 days in advance of the call date. The black line reflects expected PV savings across all simulated paths
at each quarter. The green line extends from one standard deviation above the mean to the 95th percentile.
The top of the red line begins at one standard deviation below the mean and drops to the 5th percentile of
the distribution. Note that prior to the call date the taxable advance refunding leads to lower NPV savings
overall relative to when the tax-exempt refunding is possible starting 90 days prior to the call date. We
also see the initial average reduction in NPV savings as rates rise on average within the model. Last it is
13

Negative arbitrage occurs when the yield on the escrow is lower than the refunding bond yield.
Section 148 of the Internal Revenue Code precludes issuers from earning a higher yield on the escrow than the
arbitrage yield on tax-exempt refunding bonds.
14

15

important to note that the refinancing rate is rolling down the simulated yield curve as the bond
approaches maturity. This last fact explains why there is declining savings variability as we approach
maturity.
20Y Maturity, Callable in 3Y
Refunding Criteria - 5% PV Savings Threshold
25

Assuming the borrower

Tax-Exempt Adv Refunding

20

savings threshold (common in

practice), we can calculate
expected present value (EPV)
savings by appropriately

EPV Savings / $100

refunds the bonds at a 5% NPV

Taxable Adv Refunding

Current Refunding Only

15

10

discounting and averaging

Refunded Bond Coupon

across all simulated

Figure 4

environments. In Figure 4, EPV savings is shown for three different bonds types: one allowing for taxexempt refunding (blue); one that can be advance refunded only taxably (orange); and one that we specify
may only be refunded on a current basis i.e. no more than 90 days in advance of the first call date (green).
At lower coupon levels, EPV savings for all bond types is similar indicating that refunding is happening
at similar times, in this case close to maturity. In the coupon range over 5.25%, exercise happens very
quickly or even immediately. In this range, the taxable advance refunding fares poorly relative to either
the tax-exempt advance refunding or waiting for the current refunding near the call date. Note that there is
a middle region, however, with a coupon range between 4.75% and 5.25%. Here the refunding criteria of
5% PV savings impacts EPV savings in unintuitive ways. Despite higher coupons, EPV savings actually
falls in certain cases because the refunding decision in the lower coupons is delayed such that NPV
savings at a later time is higher, perhaps due to less negative arbitrage in the escrow.
It is important not to generalize too much from this example. The 5% NPV savings refunding
criterion chosen, though common, is arbitrarily applied to all bonds regardless of coupon or terms. As
such, there is little we can resolve dispositively about these three bonds or their embedded options. For
16

instance, it would be incorrect to take these results as proof that either advance refundings always destroy
value, or alternatively that it is always more advantageous to wait until the call date to refund.15 Without
optimal exercise criteria, these assessments cannot be accurately made.16
In Figure 5 we provide visualization of an optimal exercise boundary for a municipal bond option
given a certain set of
decision criteria. The

5% Bond - 18Y Maturity, 8Y Call

Optimal Exercise Boundary

coloring of this chart

NO REFUNDING REGION
shows the percentage of
simulated markets where
certain optimal refunding
criteria have been

REFUNDING REGION

satisfied. Refinancing
rates, along the y-axis,
are bucketed such that if

Figure 5

100% of the refinancing

rates in a rate bucket for a given time period correlate to satisfying the refunding criteria, then the
rectangle is green. If in turn the number of rates satisfying the refunding criteria is 0%, the rectangle is
red. A color gradient corresponds to the intermediate values. Note that the greater the time to the call date
remaining, the greater the area of either yellow or red, indicating little or no refunding. This results from
the role of the other important variable not directly observed in this graph, the escrow yield. Negative
arbitrage is significant in those areas where, despite a very low refinancing rate (even below 2%), the
region is still not one where refunding occurs frequently. This region shrinks as we move closer the call

15

(Ang, Green, & Xing, Advance Refundings of Municipal Bonds, 2013) believe they have answered this question,
though we find much of their reasoning problematic.
16
See forthcoming research Evaluating Municipal Refunding Criteria: A Simulation-Based Approach

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date. After the call there is a clear distinction as the escrow yield is no longer a factor and there is a direct
correspondence between refinancing rate and savings.

9. Conclusion
We have reviewed the problem of valuing embedded optional redemption features in callable,
fixed-rate tax-exempt bonds. From the investor and issuer perspectives as takers of nonzero risk positions,
we show that appropriate analysis of these features should be done using real-world term-structure
models, not relative pricing models. The latter are designed with other essential objectives in mind with
an emphasis on calculation speed and ease of calibration to market-traded instruments. Recent research
offers promising new ways of simulating history-consistent tax-exempt, taxable, and escrow yield curves.
We introduce the concept of expected present value (EPV) savings and describe how it is calculated using
a regime-switching, multiple-market yield curve model. In forthcoming research we will use these
methods to shine new light on the $1.5 trillion in callable, fixed-rate municipal bonds outstanding.

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