Modeling Municipal Yields With (and Without) Bond Insurance

Abstract

We develop an intensity-based model of municipal yields, making simultaneous use of the credit default swap premiums of the insurers and both insured and uninsured municipal bond transactions. We estimate the model individually for 61 municipal issuers by exploiting the dramatic decline in credit quality of the bond insurers from July 2007 to June 2008, and decompose the municipal yield spread based on the estimated parameters. The decomposition reveals a dominant role of the liquidity component as well as interactions between liquidity and default similar to those modeled by Chen et al. [Chen H, Cui R, He Z, Milbradt K (2018) Quantifying liquidity and default risks of corporate bonds over the business cycle. Rev. Financial Stud. 31(3):852–897.] for corporate bonds. Toward the end of the sample period, our model also reproduces the “yield inversion” phenomenon documented in the literature. This paper was accepted by Neng Wang, finance.