SSRN Id2431275

Towards a Better Policy: Analyzing
Municipal Refundings using a

Real-World Market Model
Peter Orr
David de la Nuez
Intuitive Analytics LLC
(Working Paper, 4/30/2014)
We greatly appreciate the contributions of Municipal Market Advisors and Delphis Hanover Corporation
for municipal yield curve data used in this paper. We also extend our gratitude to the MathWorks for
helping us expedite certain resource heavy calculations. Any errors are entirely our responsibility.
2014 Intuitive Analytics LLC. All rights reserved. Short sections of text, not to exceed two paragraphs, may be
quoted without explicit permission provided that full credit is given to the source.
Electronic copy available at: http://ssrn.com/abstract=2431275
Abstract
In the $3.7 trillion municipal bond market, the timing of a refunding is an important
decision: refund too early and the opportunity for greater budgetary benefit may be
precluded; refund too late and an attractive rate market may never return. We argue that
reliance on simple heuristics or arbitrage-free option models to derive a refunding policy
is inappropriate because hedging exposure to municipal securities is hard or even
impossible. Instead, we propose a usable, powerful real options framework to evaluate
competing policies. The framework is based on two main elements: (i) the concept of
expected present value (EPV) savings, which provides an objective criterion to evaluate
success; and (ii) a real-world interest rate model (Deguillaume et al, 2013) capable of
simulating tax exempt and Treasury yield curves simultaneously and consistent with their
historical correlation and volatility structure. In our simulation we analyze 30 variations
on popular policies, as well as an alternative policy. This framework can be used both by
issuers to maximize the expected value of their call options, and by investors, to value
and manage risk in callable municipal bond holdings.
Electronic copy available at: http://ssrn.com/abstract=2431275
1. Introduction
Of the roughly $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. Issuers usually fund an optional redemption through a refinancing bond issue called a
refunding which may include an associated escrow to satisfy the remaining bond cash flows. Investors are
interested in the timing of these refundings as it means potential re-investment risk or possible price
appreciation due to the credit support provided by escrow cash flows secured by US Treasury-issued
securities.
Though these embedded optional redemption features walk and talk like standard bond options as
have been studied for many decades, municipalities own them in an environment where they effectively
cannot be sold or hedged: thus, the problem of optimal exercise resembles more a real option model than
a problem of arbitrage-free valuation.3 4 Despite this, the majority of research to date on this topic
revolves around attempting to use standard, no-arbitrage option models to shed light on the issuers
exercise decision. For instance, (Ang, Green and Xing, Advance Refundings of Municipal Bonds 2013):
claim that advance refundings should never be carried out based on a no-arbitrage argument. They explain
that a swap that lowers payments today for higher payments after the call date can achieve the same
cashflows more efficiently and preserves the option on the original bond. Yet in another paper, (Ang,
Bhansali and Xing, Taxes on Tax-exempt Bonds 2010) the authors explain at some length the difficulty,
even illegality for issuers, of hedging municipal bonds. In practice and particularly in light of the recent
financial crisis and the resulting increased credit scrutiny of, if not outright exit by banks from the
Source: Report on the Municipal Securities Market, U.S. Securities and Exchange Commission
Source: Bloomberg, August, 2013
3
For an interesting treatment of how to analyze American options that cannot be sold, see (Ahn and Wilmott 2005).
4
This fact is described in detail by (Rebonato and Nawalkha, What Interest Rate Model to Use? Buy side versus Sell
side 2011) and more specifically in a tax-exempt setting by (Orr and de la Nuez 2013).
2
municipal swap market, only a few of the largest state and municipal players can avail themselves of the
swap markets easily.5
In this paper we assume that hedging and arbitrage are prohibitively difficult and as such we
consider the optimal refunding policy as a real option exercise problem, such as the problem a CEO faces
when deciding whether to make an irreversible investment (e.g. to build a manufacturing plant), instead
of a financial option hedging problem. Thus, we examine several popular refunding policies under a realworld market model based upon recent interest rate research by (Deuillaume, Rebonato and Pogudin
2013) which identifies a universal relationship in how interest rates have changed historically. This type
of model not only is far more realistic than standard, no arbitrage bond option models, it is also powerful
enough to provide for modeling the myriad refunding policies used in the municipal market. 6 This
provides a mode of analysis that has been unavailable to date.
In the next few sections we describe the data used in this paper, an overview of the methodology
involved in generating real-world market environments with a regime-switching model based upon
Deguillaume et al (2013), the calculations required for evaluating refunding policies in this setting, and a
comparison of the policies themselves with a combination of refunding criteria that dominates others that
we tested within this setting. Next we test the robustness of our conclusions by looking at various changes
to our model inputs. Last we look at avenues for further research.
2. The Data
The full data used in the analysis is set forth in Table 1 below.
As a former JPMorgan municipal swaps professional, the lead author of this paper believes he has the authority to
make such a statement without a confirming source.
6
Note that no-arbitrage option pricing models can be derived by using a change of measure from real to risk-neutral
worlds, leaving the volatility structure unvaried. Indeed, very recent research by John Hull and Alan White, (Hull
and White, A Generalized Procedure for Building Trees for the Short Rate and Its Application to Determining
Volatility Functions 2014) supports the research of de Guillaume (2013) et al finding exactly this type of regimeswitching interest rate model is superior to standard models in a no-arbitrage, relative pricing context. Using a
generalization of their popular model (Hull and White, Pricing interest-rate derivative securities 1990) they find that
such a calibrated three stage, regime-switching model performs nearly twice as well as standard lognormal or
normal short-rate models.
Table 1 Tax-exempt and US Treasury Data

Series
Tax-Exempt AAA Yields7
Begin Date
February 3, 1964
End Date
March 28, 2013
Series Length
12,752
US Treasury Securities / SLGS proxy 8
February 3, 1964
March 28, 2013
12,752
A chart of the Tax-exempt and US Treasury yields used in the data set over time are shown in
Figures 1a and 1b, respectively. In order to create taxable issuer market yields we add a maturity-varying
but static spread to all US Treasury tenors. Figure 1c shows the spreads to these tenors used in the paper.
3. A Real-World Market Model for Refundings An Overview
In this section we provide an overview of the market model used to generate real-world and
history-consistent yield curves from markets relevant to the issuers refunding decision: issuer taxexempt, issuer taxable, and United States Treasury issued State and Local Government Securities
(SLGS).910 A complete treatment may be found in (Deguillaume, Rebonato and Pogudin 2013). Though
not intended to be an exhaustive description, we hope it provides both some intuition behind the
modelling approach and at minimum evidence of success, namely that the simulation reliably creates
long-term, history-consistent municipal, taxable, and escrow market simulations. The reason for the
success of (Deguillaume, Rebonato and Pogudin, The nature of the dependence of the magnitude of rate
Data from January 2, 2002 through March 28, 2013 from the AAA Median yield data provided by Municipal
Market Advisors. Data from February 3, 1964 through December 31, 2001 provided by Delphis Hanover 100
(AAA) Yield Scales.
8
SLGS yields for simulated escrows are derived from US Treasury data from the St. Louis Federal Reserve data
repository (FRED); one basis point is subtracted from simulated US Treasury yields per current SLGS
specifications.
9
See (R. Rebonato, Mahal, et al. 2005) for a description of history consistent yield curves, their importance to
financial analysis, and the challenges involved in their creation.
10
SLGS are assumed to be the securities held in the event of a refunding prior to the optional redemption date of the
bonds. See https://www.treasurydirect.gov/govt/apps/slgs/slgs.htm for more detailed information on SLGS.
moves on the rates levels: a universal relationship 2013)s model is that it identifies a universal
relationship in how interest rates have changed historically:
We show that the most convincing explanation for the observed dependence of the magnitude of
rate changes on the level of rates is a function with three regimes: when rates are very low (say,
below 1.5%), changes appear to be proportional to the level. For rates between, approximately,
1.5% and 5% changes appear to be independent of the level of rates; above 5% we find that
proportionality prevails again, although possibly with a different slope. The relationship that we
empirically find is surprisingly robust across currencies, rate maturities and time periods. Indeed,
we show that we find the same three-regime relationship (although with somewhat different break
points) even using UK Consol yields going back to the XIX century!
Deguillaume et als method is a combination of parametric modeling and simulation by
historical sampling. Historic yield changes are normalized according to a well-defined mapping that
recognizes the existence of the three regimes, then sampled, and then rescaled to match the current
regime. This has the effect of producing credible interest rate simulations while at the same time allowing
for parametric regime-switching between three persistent regimes. Readers less interested in these
modeling details can proceed directly to Section 4 with little loss of meaning.
The Market Simulation Approach
The basic approach to creating simulated market environments as laid out in the new research is
straightforward and involves historical sampling. Essentially, we take a window of historic data and use
the yield changes in that window to simulate rate changes going into the future. For example, a window
length of 100 days might be used to sample from ten years of historic daily data. The start point for each
window is randomly selected from a uniform distribution. In order to properly capture the intra and intermarket correlation between different tenors, we model all yield changes for each tenor using the same
selection of windows.
Today
Window 1
Window 2
Window 3
Window 4
Future
History
One of the benefits of this approach is it captures the tendency for yields to move in trends i.e.
serial autocorrelation. A challenge occurs at the short end of the yield curve where, due to central bank
management of business cycles, autocorrelation may last for years. However, using a long window on the
order of years may affect the randomness of the scheme, depending in part on the size of the data set used.
Our starting point for the model uses a window length of 100 days.11 Later we show that our results are
robust to different specifications.
Some Market Model Details
In order to implement the regime-switching, Deguillaume et al (2013) define a class of volatility
function for yields (y) which incorporates three regimes based upon rate level,
( )
(
The parameters yL, yR, and K can be calibrated using historical interest rate data. The terms yL and
yR are the lower and upper rate thresholds respectively indicating where the breaks occur between normal
and (approximately) lognormal regions. K is the slope of the line when rates are in the high region. Note
that cannot become negative and is bounded at zero.
In order to perform this calibration for the municipal market we replicated the work of
Deguillaume et al (2013) and applied it to the daily tax-exempt data described in Section 2. Our results in
the US municipal market confirm that the calibration method is more stable for values of yL but less so for
11
See (R. Rebonato, S. Mahal, et al. 2005) for more information on window selection in this setting.
values of yR and K. That said and as we will show, we find a good fit for all tenors in both tax-exempt and
US Treasury markets by using the following values,12
Parameter
yL
yR
K
Value
1.50%
6.00%
25.0
In order to generate simulations we randomly sample start dates for windows of historical yield
changes, transform the data using what Deguillaume, et al call a function (a bijection and in some sense
a discretized version of the function above), and add those transformed changes to the current market to
create a simulated real-world environment into the future.
Consider the function a type of generalized logarithm which handles more complex rate
variations than a simple percentage change of rate level. In essence, the function achieves a type of
disguise. That is, after the transformation is applied it is very difficult to tell in which type of rate
environment the change actually occurred. In short it is a type of normalization of interest rate variation
that allows all data to be treated equally in what the authors call the additive world. This is an extremely
powerful result and remarkably convenient for generating real-world interest rate simulations. In the case
of municipal market issuers and investors, it is the real-world market that needs modeling.13
Reversion
The model described by Deguillaume et al provides for both a level reversion mechanism for the
longest (least volatile) yield as well as a shape median reversion for all other tenors. The former keeps the
long tenor bounded and in the range of reasonable rates like any mean-reverting yield curve model and
the latter keeps the shapes of the simulated curves from becoming unrealistic over time. Each of these
values is calibrated from historical data. In our analysis tax-exempt yields include 13 tenors: 3 month and
12
Recall the issuer taxable curves are a fixed spread in all simulations over the US Treasury curve. See Figure 1c.
Without getting bogged down in measure theory and the Fundamental Theorem of Asset Pricing, note that in a
setting where a financial position can and is hedged, so-called risk-neutral valuation and management techniques
embodied in standard no-arbitrage models beautifully apply. However, in the case of unhedged municipal bonds
(issuers and investors), the real-world measure and risk-preferences are both required.
13
1-5, 7, 10, 12, 15, 20, 30, and 40 years. The SLGS component has 3 and 6 month tenors, as well as 1-5, 7,
10, 12, 15, 20, and 30 years, twelve in all. In standard yield curve modeling parlance this would be
considered a 25 factor model. Calibrating to the data set, we find annual median reversion and shape
median reversion to be 12% and 72% respectively. Tax-exempt and SLGS yield curves towards which
rates will revert in the model are shown in Figures 2a and 2b.
The authors have also developed an analytic approximation for rate distributions in the model
which is convenient for confirming results of the calibration. This analytic approximation is not defining a
separate distribution and fitting it to the model, but rather using the changes of rates as the distribution
itself. Figure 3 shows the distribution of the 30 year SLGS rate in 30 years relative to a histogram of
10,000 simulated 30-year SLGS rates.
Figure 3
SLGS 30 Year Tenor at 30 Year horizon
Figures 4a-d plot the .5th, 2nd, 5th, 25th, 50th, 75th, 95th, 98th and 99.5th percentile at various points
in time between zero and thirty years comparing an analytic approximation of the distribution of the 2, 5,
10, and 30 year tenors with the same percentiles from the simulated data. These figures were generated
using the following inputs,
Number of Simulations
Simulation Horizon
Window Length
Long tenor reversion speed (annual)
8
5,000
30 Years
100 Days
11.8%
Shape reversion speed (annual)

Data Increment
71.7%
1 Business Day
We see a very close correspondence between analytic approximations of the distribution based
upon the sample data itself and simulated distributions throughout the horizon of the analysis. Figures 5ad provide the same information for the US Treasury/SLGS data. Again we see a very close match
between analytic approximations of the distributions and the simulated data, even at the fat-tail extremes
of the .5th and 99.5th percentiles.
The most difficult visual test for a yield curve model like this, particularly one that spans multiple
markets, is to see how tenors move together i.e. the plausibility of all market yield curves actually
generated within the model. In Figure 6 we show 10 randomly generated market yield curves for two
markets at the 30 year time point. The top half shows tax-exempt issuer yield curves comprised of the 13
tenors used in the tax-exempt market while the bottom half shows the 12 tenors used in the SLGS
simulation.14 Notice that the line colors between the two graphs reflect a simulation from the same market
environment. For example, the top green line in the tax-exempt graph corresponds to the market
environment of the green SLGS yield curve in the bottom half of the Figure. Even with this small number
of samples, we can see the greater variability in the shape of the SLGS curves.
4. Calculating Expected Present Value (EPV) Savings and the Utility of the Issuer
Armed with simulations of consistent tax-exempt, taxable, and SLGS yield curve environments,
we are prepared to evaluate refunding policies. We first calculate the present value savings to the date of
each simulated market environment using a par refunding bond priced from our simulated tax-exempt
yield curve with a maturity matched to the refunded bond; in our base case the refunding bond is noncallable.15 An escrow is sized as necessary using the simulated SLGS curves. We then further discount
14
One of the benefits of this model is that matching tenors across markets is not a requirement. The historical
sampling method is indifferent to the data selected
15
See Section 6 on second generation refundings for relaxation of this assumption
present value savings along the relevant path, using the simulated 3 month tax-exempt rate as we go, to
arrive at a correct calculation for present value savings on the Valuation Date from every simulated
environment.
Figure 7 below shows a 100 bucket histogram of present value savings at quarterly intervals in
the PV savings simulation for a 5% coupon bond maturing July 1, 2022, callable July 1, 2015. Note how
savings in all environments decays as we approach maturity of the bond in 2022 on the right hand side of
the figure.
Figure 7 Simulated PV Savings

5% Bond Maturing 7/1/22, Callable 7/1/16
Given we have a type of payoff for the option in current dollars in every future state of the world,
we are left now to simply capture the refunding policy that will trigger the refunding along each simulated
path. In order to do this we calculate all criteria necessary to fully specify each refunding policy as a
given policy may contain multiple criteria.16
When we apply a refunding policy we simply evaluate along each simulated market environment
when that policys criteria are satisfied and take that environments present value savings to be the one
16
Note that for a 30 year bond with 10,000 monthly simulations this requires roughly 3.6 million calculations for
each criteria in a policy.
10
realized for that path. Averaging across all paths gives us what we call expected present value (EPV)
savings for the bond. This may be presented in dollar terms or in the case of this paper, as a percentage of
the par amount of the refunded bond or bonds.
EPV Savings Option Value or Price?
Some may recognize the procedure above as a standard approach for valuing or pricing an option
using a Monte Carlo method, but in this setting we argue it is neither. This calculation generates neither
the entire option value to an issuer nor the option price. It is not the option value because from the issuers
perspective an optional redemption feature may be worth considerably more than just the potential for
interest cost savings that may result from a high-to-low refunding.17 Other possible motives for calling
bonds prior to maturity may include retiring an indenture with restrictive bond covenants, reduction of
debt to improve key financial ratios, use of windfall cash, a merger requiring certain debt limits, and other
strategic reasons for shrinking the balance sheet. These are unique to each issuer and although difficult or
even impossible to quantify, should not be overlooked when calling a metric the option value. And
EPV savings is clearly not the option price because the option is not traded or tradable, and it does not
have a price.18 For these reasons, we will use the term EPV savings throughout and not option value or
option price.
Given we are in a real-world setting, how do we address the thorny matter of the issuers utility or
risk preferences as it relates to refundings? For purposes of this analysis we assume the objective is to
simply maximize EPV savings; the refunding policy with the highest EPV savings wins. We re-introduce
the risk preferences again in Section 6 below.
5. Comparison of Refunding Policies
17
This is an industry term for a refunding where the old coupon on the existing bond is high and replaced with a
new one low generating some amount of interest cost savings.
18
This is largely due to the fact that there is no underlying market but also because neither issuers nor investors
hedge these positions, as has been discussed. Therefore, for these purposes market implied inputs would be
inappropriate either way.
11
To test refunding policies, we create a portfolio of 220 bonds with coupons, maturities and call
dates as shown in Table 2.19
Table 2
220 Bonds in Refunding Policy Comparison
1
2
3
4
5
Years to Maturity 6
After Call 7
8
9
10
11
12
13
14
15
16
17
18
19
20
0
1.0%
1.0%
1.0%
1.0%
2.0%
2.0%
2.0%
2.0%
2.0%
3.0%
3.0%
3.0%
3.0%
3.0%
4.0%
5.0%
5.0%
5.0%
5.0%
5.0%
1
1.0%
1.0%
1.0%
2.0%
2.0%
2.0%
2.0%
2.0%
3.0%
3.0%
3.0%
3.0%
3.0%
4.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
2
1.0%
1.0%
2.0%
2.0%
2.0%
2.0%
2.0%
3.0%
3.0%
3.0%
3.0%
3.0%
4.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
Years to Call
3
4
1.0%
2.0%
2.0%
2.0%
2.0%
2.0%
2.0%
2.0%
2.0%
2.0%
2.0%
3.0%
3.0%
3.0%
3.0%
3.0%
3.0%
3.0%
3.0%
3.0%
3.0%
4.0%
4.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5
2.0%
2.0%
2.0%
2.0%
3.0%
3.0%
3.0%
3.0%
3.0%
4.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
6
2.0%
2.0%
2.0%
3.0%
3.0%
3.0%
3.0%
3.0%
4.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
7
2.0%
2.0%
3.0%
3.0%
3.0%
3.0%
3.0%
4.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
8
2.0%
3.0%
3.0%
3.0%
3.0%
3.0%
4.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
9
3.0%
3.0%
3.0%
3.0%
3.0%
4.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
10
3.0%
3.0%
3.0%
3.0%
4.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
Most of these bonds are premium coupons relative to current yields though this is irrelevant to the
calculation of EPV savings as described above.
In Table 3 we describe the various criteria that comprise the 30 standard refunding policies we
test.20 Combinations of criteria were explored to see if any exhibited unexpected results. In order to test
refunding efficiency-based policies we calculated Black-Karacinski option values in each simulated
market environment using a low annual mean reversion speed of 1% and flat volatility curve at 14%
annually.21 22
19
Note that this portfolio is identical in structure to the historical analysis presented in ???
Unfortunately we were unable to include the New York State and NY Metropolitan Transit Authority refunding
table within the timing deadline.
21
Though these BK parameters are largely arbitrary, they are consistent with settings proposed by market
participants for this purpose.
22
Calculating BK values for all 220 bonds over all simulation points was our most computationally intensive task in
this research.
20
12
Figure 8 below graphs the average EPV savings as a percent of refunded par for the 30 criteria
plus an Alternative Policy we describe in more detail in the next section. Table 3 shows the percentages in
rank order of performance.
10%
Figure 8
Expected PV Savings of Refunding Policies
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
Analysis
Though exploring all 31 policies individually goes beyond the scope of this paper, there are some
broad themes discernible from the information. First note that the information content of the Escrow
Efficiency criterion for threshold values from 50% to 90% is zero. This can be seen by the fact that the
EPV Savings for the 3% Savings policy is identical to the EPV Savings for the 3% Savings policies plus
Escrow Efficiencies from 50 to 90%. The same relationship holds true when looking at a 5% Savings
alone and combined with Escrow Efficiency from 50% to 90%. At 95% or even 100% Escrow Efficiency
however, EPV Savings does improve, sometimes materially.
13
Also note the Negative Arbitrage / Savings criterion contains a fair amount of information value,
sometimes on its own. Note that the policy combining a 25bps Savings threshold with 20% Negative
Arbitrage / Savings is the fourth best performing of the list.
Refunding efficiency at the 90% and 85% level perform reasonably well at rank 5 and 6
respectively. However higher thresholds begin to erode EPV Savings performance. 95% Refunding
Efficiency delivers just over 6% EPV Savings and 100% is the worst performing Policy of the group
generating only 3.33% EPV Savings.
A policy of 100% refunding efficiency (which rarely leads to advance refunding) performs worst
of all. Ang et al (2013) claim that [municipalities] got lucky (p. 30): in the recent past, advance
refundings destroyed very little value ex-post because of the general downward trend of interest rates
over the last 15 years. Our market simulations, however, are not based on a single secular trend in
interest rates and the estimated savings are ex ante. This result is a powerful argument in favor of a realworld, real-options framework to evaluate refunding policies, as opposed to a no-arbitrage one; as well as
a powerful caveat against rushing to ban advance refundings altogether.
6. A Better Policy Alternative
In addition to the policies we show in Section 5, we programmatically searched for different
combinations of criteria that led to high levels of EPV Savings. We do not consider this search exhaustive
however given the combinations we tested, certain criteria together dominated other policies. We next
used constrained optimization to fine tune the policy parameters and the EPV Savings results improved
further.
In order to ensure our findings were not based upon data mining or policy over-specification we
decided to test the Alternative policy using the single most relevant simulation of all, history. Research
results evaluating all the policies in this paper and a few others including the Alternative Policy over a 50
year period can be found in, (Orr and de la Nuez, Analysis of Municipal Refunding Policies: A 50 Year
Historical Approach 2014).
14
The Alternative Policy consists of a combination of 2 criteria. One is a basic savings threshold
and the second we call a delta criterion. The delta criterion is similar to that of a standard options delta:
the change in option price per change in underlying. However, this delta is similar in the sense that we are
measuring the change in present value cash flow savings based upon a shift in market yields.
[to complete]
7. Testing Robustness
In order to test the robustness of our results we performed tests along two dimensions; changing
volatility and changing the drift. Each of these tests and their impact on results are described in the
subsections that follow.
Changing Volatility by Changing Data Sets
There are two primary ways that volatility can change within the model. First we explored the
impact on EPV Savings resulting from changing the sampled data set itself. Figure 9 shows the change in
EPV savings for 9 bonds with coupons ranging from 2 to 6%. The horizontal axis of the chart indicates
the data start date for the simulations in the EPV calculations whereas the end date remains fixed at
March 28, 2013. Along the horizontal axis we move forward in 5 year increments up to January 1, 2010.
For example, the data sampled for the EPV values on the far left of the chart begins on February 3, 1964
up to fixed data end date. The data used to create the EPV values for all 9 bonds on the far right of the
chart are sampled from only the 39 months from January 1, 2010 to March 28, 2013.
Evident in Figure 9 is the dramatic effect on EPV savings of the decrease in interest rate volatility
as we move out of the historical period of the 1970s and early 1980s. The inflation of the 70s and the
monetary experiment in the early 80s were periods that had a great deal more rate volatility than the last
30 years or so. This leads to a very simple but powerful question when using this framework to perform
analysis: in looking to the future from today, what period of interest rate history is relevant? Are periods
of extreme monetary instability like the US experienced in the 1970s likely in the future? Or as Milton
15
Friedman suggested in 2003 has the Feds thermostat now become fairly accurate?23 Contrast this type of
discussion with the unintuitive and rather arbitrary selection of 14% or similar volatility level required of
standard, no-arbitrage lognormal short-rate models.
Though it is clear the absolute level of EPV Savings for a given policy is impacted by the
historical period used in generating the simulated markets, the relative performance of various policies
was virtually unchanged. And again the Alternative Policy bested the others.
Changing Volatility by Changing Window Length
The second way to change the effective volatility is to modify the window length. In our basic
analysis we used 100 days which was the shortest window length that (R. Rebonato, Mahal, et al. 2005)
found consistent with capturing the autocorrelation evident in yields. In order to test our results, we
changed the window length in 100 day increments up to 1,000 days, or about 4 years. Figures 10a-d
shows four charts using 100 day windows. The charts calculate EPV Savings at differing savings criteria
with varying levels of time to the call date, coupons, time to maturity with a 4% bond, and time to
maturity with a 5% bond respectively. Figure 11a-d shows the same information with 1,000 day windows.
Comparing like graphs between subcharts 10 and 11 shows a generally lower level of realized rate
volatility for the 1,000 day window simulations relative to the 100 day. This is evidenced by the lower
amounts of EPV savings across the board. Similar to the effect of changing the data set, this decreased
volatility changed the performance of policies in an absolute sense, but not a relative one. The Alternative
Policy again still dominates in our tests.
Long Horizon Rates Different Forecasts
Perhaps the most important set of assumptions in the market model that might drive changes in
relative refunding policy performance are the long horizon yield curves towards which the issuer and
SLGS markets revert. In order to test these assumptions, we ran the analysis under two separate forecasts
23
See the article The Feds Thermostat in the Wall Street Journal online.
16
designed to test high and low forecast extremes. Figures 12a and 12b shows low, high and base case (or
Medium) long-horizon yield curves towards which the tax-exempt and SLGS yields revert.
Given the importance of this test, we ran a complete analysis using both high and low forecasts.
Graphic results are shown below in Figure 12 and numerical details are provided in Table 5.
Figure 12
EPV Savings per Refunding Policy
Low, Base, and High Case Long-Horizon Yield Curves
12%
10%
Low
Base
8%
High
6%
4%
2%
0%
As expected, the high (low) yield forecast corresponds to the generally lowest (highest) EPV
Savings line, with the base case in black between the two. The slope of the scenarios tends to increase as
we go from high rate scenarios to low rate ones, indicating a greater differentiation in policy performance.
In general the policy ranking holds irrespective of the level of long-horizon yields. The one
exception is 95% refunding which appears to match its outperformance in low rate environments with
17
underperformance in higher rate ones. As yet we have no explanation for this anomaly. Again, the
Alternative Policy dominates the others in all three scenarios.
8. Second Generation Refundings and Comprehensive Refunding Decisions

If a bond is being refunded by a bond that is itself callable, then any complete economic analysis
of executing the refunding should also include some estimate of the value of the option embedded in the
refunding bond.24 However, we cannot find anything in the literature attempting to estimate the value of
refunding the refunding bond, despite the fact that it is the exact same component of economic value
described above and should not be disregarded. Why should the value of an embedded refunding bond
call option be considered only if the refunding bond is issued today, and not a year or two or even five
years from now? We believe it should.
Within the modeling framework described in this paper such an analysis is straightforward if
computationally intensive. In order to calculate second generation expected present value savings (EPV2),
we must track the terms of the refunding bond when it is (hypothetically) issued and then apply a
refunding policy to it in order to assess any savings generated along that sample path from that point
forward. Complicating the analysis is the limitation that under current tax law an advance refunding bond
is itself not eligible for refunding on a tax-exempt basis more than 90 days before its call date.25 We have
addressed this in our analysis by either providing for taxable advance refundings more than 90 days prior
to the call date or only executing current refundings as specified in the refunding model.
Table 6 below shows EPV2 for 2nd generation refunding policies (across the columns) against
first generation policies (along the rows).
24
See for example (Kalotay, Yang and Fabozzi, Refunding efficiency: a generalized approach 2007)
See Section 148 of the Internal Revenue Code for more information and consult tax counsel regarding any
specific circumstances
25
18
Table 6a
2nd Generation Refunding Savings
2nd Generation
No Call 3% Savings 5% Savings
5% Savings &
95% Esc Eff State of WI Alternative
1st Generation
No Call
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
3% Savings
0.0%
3.8%
3.7%
3.7%
3.8%
4.3%
5% Savings
0.0%
3.8%
3.7%
3.7%
3.8%
4.3%
5% Savings & 95% Esc Eff
0.0%
3.6%
3.6%
3.6%
3.6%
4.1%
State of WI
0.0%
2.8%
2.6%
2.6%
2.8%
3.2%
Alternative
0.0%
1.5%
1.3%
1.3%
1.5%
1.6%
We find it inconsistent that the cash flow savings inherent in refinancing the refunding bond
should only happen if the refunding occurs today.
[to complete]
9. Avenues for Future Research
The power of this modeling framework rests in its ability to create real-world simulations from
multiple fixed income markets simultaneously, and as a result bring greater realism than heuristics or
standard, single-factor lognormal or normal short rate pricing models could provide. This opens up many
avenues for future research and investigation:
a) Incorporate aggregate refunding criteria such as minimum refunding par
b) Add more realism to couponing structure of refunding bonds including premium bonds
c) Include notice provisions and other realistic decision criteria related to market movements
d) Model, compare, and optimally determine complete new money and refunding bond issues
incorporating the non-linear effects of escrow construction
e) Determine optimal issuance strategies for variable and fixed-rate bonds with a comparison of
net capital cost on a distributional basis
f) Perform real-world VaR and other risk-management analysis for investors based upon
issuers stated (or likely) refunding policies
g)
19
10. Conclusions
Today tax-exempt issuers and investors are respectively long and short embedded call options in
approximately $1.5 trillion tax-exempt bonds. The analysis of these features is complicated by the fact
that the vast majority of issuers cannot effectively hedge or sell these positions. This circumstance renders
the use of standard, no-arbitrage bond option models inappropriate. Both risk preferences and the issuer
or investors market view must be considered.
In this paper we use a real-options approach to the problem employing a real-world market model
based upon recent interest rate research (Deguillaume et al 2013) capturing tax-exempt, taxable, and
escrow markets simultaneously. With it we evaluate 30 refunding policies plus an Alternative Policy that
we find dominates the others under a variety of volatility and drift changes to the market model. These
results also provide compelling evidence against legislative action banning municipal advance refundings.
20
REFERENCES
Ahn, Hyungsok, and Paul Wilmott. "On Exercising American Options: The Risk of Making More Money
than You Expected." Wilmott Magazine, 2005: 52-63.
Ang, Andrew, Richard C. Green, and Yuhang Xing. "Advance Refundings of Municipal Bonds."
National Bureau of Economic Research Working Papers. August 3, 2013.
http://www.nber.org/papers/w19459.
Ang, Andrew, Vineer Bhansali, and Yuhang Xing. "Taxes on Tax-exempt Bonds." Journal of Finance 65,
no. 2 (2010): 565-601.
Deguillaume, Nick, Riccardo Rebonato, and Andrey Pogudin. "The nature of the dependence of the
magnitude of rate moves on the rates levels: a universal relationship." Quantitative Finance,
2013: 351-367.
Deguillaume, Nick, Riccardo Rebonato, and Andrey Pogudin. "The nature of the dependence of the
2013: 351-367.
Deuillaume, Nick, Riccardo Rebonato, and Andrey Pogudin. "The nature of the dependence of the
2013: 351-367.
Hull, John, and Alan White. "A Generalized Procedure for Building Trees for the Short Rate and Its
Application to Determining Volatility Functions." Social Science Research Network. April 17,
2014. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2399615 (accessed April 24, 2014).
Hull, John, and Alan White. "Pricing interest-rate derivative securities." The Review of Financial Studies,
1990: 573-592.
Kalotay, Andrew, Dean Yang, and Frank J. Fabozzi. "Refunding efficiency: a generalized approach."
Applied Financial Economics Letters 3 (2007): 141146.
Orr, Peter, and David de la Nuez. "Analysis of Municipal Refunding Policies: A 50 Year Historical
Approach." 2014.
. "The Right and Wrong Models for Evaluating Callable Municipal Bonds." Social Science Research
Network. October 22, 2013. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2343897
(accessed December 14, 2013).
Rebonato, Riccardo, and Sanjay K. Nawalkha. "What Interest Rate Model to Use? Buy side versus Sell
side." January 1, 2011. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1723924 (accessed
June 15, 2013).
Rebonato, Riccardo, Mahal, Joshi, Bucholz, and Nyholm. "Evolving yield curves in the real-world
measures: a semi-parametric approach." Journal of Risk, 2005: 29-61.
21
Rebonato, Riccardo, S. Mahal, M. Joshi, L.-D. Bucholz, and K. Nyholm. "Evolving Yield Curves in the
Real-World Measure: A Semi-Parametric Approach." Journal of Risk 7, no. 3 (2005): 29-62.
22
Figures
Figure 1a
Figure 1b
Figure 1c
Spreads to UST for Taxable Issuer Yields
1.2%
1.04%
1.07% 1.06%
1.00%
1.0%
0.87%
0.77%
0.8%
0.66%
0.6%
0.43% 0.44%
0.4%
0.34%
0.30%
0.25% 0.25%
0.2%
0.0%
0.25
0.5
5
Tenor
23
10
12
15
20
30
Figure 2a
Tax-exempt Starting and Long Horizon Yields, Base Case
6%
Starting Yields
5%
Long-Horizon Yields
4%
3%
2%
1%
0%
0.25
5
7
10
Tenor (Years)
12
15
20
30
40
20
30
40
Figure 2b
SLGS Starting and Long Horizon Yields, Base Case
6%
5%
4%
3%
Starting Yields
2%
Long-Horizon Yields
1%
0%
0.25
5
7
10
Tenor (Years)
24
12
15
Figure 3
SLGS 30 Year Tenor at 30 Year Horizon
Figure 4a
30Y Tax-exempt Yield Simulated vs Analytic Approximation over 30 Years
25
Figure 4b
Figure 4c
26
Figure 4d
Figure 5a
30Y SLGS Yield Simulated vs Analytic Approximation over 30 Years
27
Figure 5b
Figure 5c
28
Figure 5d
29
Figure 6
Simulated Tax-exempt and SLGS Yields, 30 Year Horizon
30
Figure 7 Simulated PV Savings

5% Bond Maturing 7/1/22, Callable 7/1/16
Figure 8
Expected PV Savings of Refunding Policies
10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
31
Figure 9
EPV Savings %, 4% PV Savings Decision Criteria
EPV Savings of 18Y Maturity, No-call 3Y Bonds Various Coupons

Changing Historical Sampling Start Date
Data Sampling Start Date
Figure 10a-d
100 Day Window
32
Figure 10b 100 Day Window
Figure 10c 100 Day Window
33
Figure 10d 100 Day Window
Figure 11a
1,000 Day Window
34
Figure 11b 1,000 Day Windows
Figure 11c 1,000 Day Window
35
Figure 11d 1,000 Day Window
36
Figure 12a
Long Horizon Tax-Exempt Yields in Low, Base, and High Cases
9%
Spot
8%
Low
Med
7%
High
6%
5%
4%
3%
2%
1%
0%
0.25
10
12
15
20
30
40
Figure 12b
Long Horizon SLGS Yields in Low, Base, and High Cases
9%
Starting Yields
Base
Low
High
8%
7%
6%
5%
4%
3%
2%
1%
0%
0.25
5
7
10
Tenor (Years)
37
12
15
20
30
40
Figure 12
EPV Savings Per Refunding Policy
Low, Base, and High Case Long Yields
12%
10%
Low
Base
8%
High
6%
4%
2%
0%
38
Tables
Table 1
Tax-exempt and US Treasury Data
Series
Tax-Exempt AAA Yields
Begin Date
February 3, 1964
End Date
March 28, 2013
Series Length
12,752
State and Local Government Securities
February 3, 1964
March 28, 2013
12,752
Table 2 220 Bonds in Refunding Policy Comparison
1
2
3
4
5
Years to Maturity 6
After Call 7
8
9
10
11
12
13
14
15
16
17
18
19
20
0
1.0%
1.0%
1.0%
1.0%
2.0%
2.0%
2.0%
2.0%
2.0%
3.0%
3.0%
3.0%
3.0%
3.0%
4.0%
5.0%
5.0%
5.0%
5.0%
5.0%
1
1.0%
1.0%
1.0%
2.0%
2.0%
2.0%
2.0%
2.0%
3.0%
3.0%
3.0%
3.0%
3.0%
4.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
2
1.0%
1.0%
2.0%
2.0%
2.0%
2.0%
2.0%
3.0%
3.0%
3.0%
3.0%
3.0%
4.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
Years to Call
3
4
1.0%
2.0%
2.0%
2.0%
2.0%
2.0%
2.0%
2.0%
2.0%
2.0%
2.0%
3.0%
3.0%
3.0%
3.0%
3.0%
3.0%
3.0%
3.0%
3.0%
3.0%
4.0%
4.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
39
5
2.0%
2.0%
2.0%
2.0%
3.0%
3.0%
3.0%
3.0%
3.0%
4.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
6
2.0%
2.0%
2.0%
3.0%
3.0%
3.0%
3.0%
3.0%
4.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
7
2.0%
2.0%
3.0%
3.0%
3.0%
3.0%
3.0%
4.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
8
2.0%
3.0%
3.0%
3.0%
3.0%
3.0%
4.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
9
3.0%
3.0%
3.0%
3.0%
3.0%
4.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
10
3.0%
3.0%
3.0%
3.0%
4.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
Table 3
Description of Criteria for Refunding Policies Tested
Criterion
Savings Percentage
OCI
OCI+
Escrow Efficiency
Negative Arbitrage / Savings
Refunding Efficiency
MTA
Description
Exercise when the present value savings as a percentage of refunded par
is greater than a given threshold such as 3%.
Consider a move downward in the refunding rate by a certain fixed
number of basis points (e.g. 10bps). If savings are not improved by more
than a given threshold (e.g. 10%), exercise at the current rate. Typically
OCI is used in conjunction with another criterion.
OCI+ is the same as OCI but with an accompanying move in the escrow
rates applied in addition to the move in refunding bond yield before
considering the change in savings.
Exercise when the escrow efficiency is greater than a given threshold
such as 90%. The escrow efficiency is the ratio of the escrow cost
yielding the refunding arbitrage yield to the realized escrow cost.
Exercise when the negative arbitrage divided by the present value savings
is less than a given threshold such as 20%. The negative arbitrage is the
difference between the realized escrow cost and the perfect escrow cost
where the escrow earns the refunding arbitrage yield.
Exercise when the refunding efficiency is greater than a threshold such as
85%. Refunding efficiency is a ratio of present value savings to option
value. Some calculate the option value using a no-arbitrage option pricing
model such as Black-Karasinski or Black-Derman-Toy.
The MTA criterion is a table-based criterion, whereby the exercise
decision is determined by a simple Savings Percentage threshold, but the
threshold depends on characteristics of the refunded bond. Those
characteristics are used to create a table of thresholds. The MTA
criterion uses years remaining to maturity and years remaining to call:
40
Table 4
Base Comparison of Refunding Policy EPV Savings
Rank
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
Policy
Alternative Policy
5% Savings, 100% Escrow Efficiency
3% Savings, 20% Neg Arb/Savings
25bps Savings, 20% Neg Arb/Savings
90% Refunding Efficiency
3% Savings, 50% Delta
6% Savings
5% Savings
4% Savings
3% Savings
41
EPV
Savings
8.75%
7.38%
7.11%
6.92%
6.81%
6.58%
6.41%
6.28%
6.22%
6.20%
6.04%
6.01%
5.90%
5.82%
5.78%
5.67%
5.66%
5.41%
5.37%
5.37%
5.37%
5.37%
5.37%
5.03%
4.77%
4.71%
4.71%
4.71%
4.71%
4.71%
3.33%
Table 5
Comparison of EPV Savings per Policy
Base Case, High, and Low Yield Curve Forecasts
Rank
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
Policy
Alternative Policy
3% Savings, 20% NegArb/Savings
25bps Savings, 20% NegArb/Savings
3% Savings, 50% Delta
6% Savings
5% Savings
4% Savings
3% Savings
42
Low
11.60%
10.39%
8.93%
8.67%
8.39%
7.69%
7.61%
7.20%
7.33%
7.42%
7.02%
8.40%
6.81%
6.70%
6.85%
6.44%
6.46%
6.13%
6.05%
6.05%
6.05%
6.05%
6.05%
5.61%
5.29%
5.18%
5.18%
5.18%
5.18%
5.18%
3.71%
Base
8.75%
7.38%
7.11%
6.92%
6.81%
6.58%
6.41%
6.28%
6.22%
6.20%
6.04%
6.01%
5.90%
5.82%
5.78%
5.67%
5.66%
5.41%
5.37%
5.37%
5.37%
5.37%
5.37%
5.03%
4.77%
4.71%
4.71%
4.71%
4.71%
4.71%
3.33%
High
6.33%
5.66%
6.27%
6.22%
5.80%
5.83%
5.95%
5.78%
5.89%
5.79%
5.67%
4.32%
5.56%
5.59%
5.57%
5.23%
5.46%
5.09%
5.05%
5.05%
5.05%
5.05%
5.05%
4.80%
4.62%
4.55%
4.55%
4.55%
4.55%
4.55%
3.02%

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Towards a Better Policy: Analyzing

Municipal Refundings using a

Electronic copy available at: http://ssrn.com/abstract=2431275

Electronic copy available at: http://ssrn.com/abstract=2431275

Table 1 Tax-exempt and US Treasury Data

US Treasury Securities / SLGS proxy 8

March 28, 2013

Shape reversion speed (annual)

Figure 7 Simulated PV Savings

8. Second Generation Refundings and Comprehensive Refunding Decisions

5% Savings & 95% Esc Eff

Figure 7 Simulated PV Savings

EPV Savings %, 4% PV Savings Decision Criteria

EPV Savings of 18Y Maturity, No-call 3Y Bonds Various Coupons

Data Sampling Start Date

Figure 10b 100 Day Window

Figure 10c 100 Day Window

Figure 10d 100 Day Window

Figure 11b 1,000 Day Windows

Figure 11c 1,000 Day Window

Figure 11d 1,000 Day Window

State and Local Government Securities

March 28, 2013

Table 2 220 Bonds in Refunding Policy Comparison

Negative Arbitrage / Savings

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