Callable Bonds: What is Special About Munis?

Abstract

This paper documents that nearly all tax-exempt (municipal) bonds with maturity greater than ten years are callable and call protection ends in ten years. The frequent use of callable debt financing by high grade tax exempt issuers, most of the municipal bonds in the sample are AAA or AA rated, is in sharp contrast to taxable corporate issuers where, consistent with agency explanations, callable debt is largely issued by below investment grade issuers. This paper provides an explanation for the popularity of callable tax-exempt debt by showing that embedded call options are a tax efficient structure for long term tax-exempt borrowing because the call option transforms taxable capital gains into tax-exempt coupon income. Recognizing the transformation of taxable capital gains into tax exempt coupon income is only valuable when bond maturities exceed investor holding periods (unrealized gains cannot be deferred) leads to an optimal tax efficient structure that is also consistent with unique features of tax-exempt debt structures documented in this paper: tax-exempt callable bonds (1) have long periods of call-protection, (2) the period of call protection does not vary by issuer or the maturity of the bond, and (3) the period of call protection is roughly equal to the maturity of the longest maturity non-callable bonds issued. Finally, the tax-advantages of callable bonds in this model are not present in Build America Bonds, taxable bonds issued by municipalities, and consistent with the model, long maturity Build America Bonds are largely non-callable.