Creating a Live Yield Curve in the Illiquid Muni Market

Abstract

Tax-exempt municipal bonds (commonly known as “munis”) are unique to the United States. In spite of its substantial size, the muni market is illiquid and lacks a robust live benchmark yield curve. Commonly available yield curves, provided by several vendors, are specified by the yields of 5% callable bonds. The yields are typically obtained by surveying major market participants. Callable yield curves are fundamentally different from yield curves in other markets. Moreover, they are often defective: they fail to be arbitrage-free, and their implied optionless curves are unrealistic. Analysts tend to use these callable curves as if they were optionless, a practice with unfortunate consequences. There is a current initiative, sponsored by the Associated Press, to create a live muni yield curve using market quotes for selected actively traded bonds. An appealing aspect of the AP curve is the transparency of the methodology. Preliminary indications are that this new yield curve could become a superior alternative to those currently available.