Callable Tax-Exempt Bonds Are Too Costly

Abstract

Virtually every longer-term tax-exempt municipal bond is callable, usually at par 10 years after issuance. Borrowers pay for the call option with an above-market coupon or by accepting a lower sale price. We explore how the value of the option compares to its cost. Is a fairly priced call option a good deal for the municipality? The remarkable finding is that the call option is undesirable, because its cost exceeds its expected benefit. Instead of issuing callable bonds at lower prices or with higher coupons, municipal borrowers should issue optionless bonds.