Towards a Better Policy: Analyzing Municipal Refundings Using a Real-World Market Model

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. In this paper, we argue that reliance on simple heuristics or even arbitrage-free option models to derive a refunding policy is inappropriate, because hedging exposure to municipal securities is very hard or even impossible for issuers. Instead, we discover and propose a novel, robust municipal refunding policy that maximizes expected present value (EPV) savings under a real-world, history-consistent interest rate model following Deguillame et al (2013). The proposed policy dominates 30 other tested policies in simulation. This real option 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.