The Next Hot Muni Controversy?

FORT LAUDERDALE – First bond insurance, then the muni ratings scale.

Now, two more near-universal facts of life in the municipal market are drawing criticism – issuers’ employing a 3% present-value savings analysis as the threshold for deciding whether or not to execute a refunding, and their habit of selling 30-year bonds with a 10-year call.  The shots were fired Sunday in a thought-provoking session at the Government Finance Officers Association Annual Conference featuring quantitative expert Andrew Kalotay.

In the course of a broad session on how bonds are priced in the current marketplace, Kalotay challenged the audience to also calculate the “option value” they forfeit when a refunding precludes the chance of future deals.

“I’ve seen financial advisers’ reports that say ‘we’ve confirmed the calculated savings are accurate,’” he said.  “Well, big deal.  That’s the beginning of the analysis, not the end.”

Calculating the value of the option requires some higher math, but there are off-the-shelf software programs that can do the work on a typical desktop computer quickly and relatively cheaply.  In the early 1990s, it could take several seconds to value a single bond with a computer using an Intel 386 processor.  Today, he said the typical “Quad-Core” desktop can perform 120,000 of those calculations per minute.

But Kalotay’s recommended approach doesn’t stop there:  He pressed the issuers to also account for the option value they’d take on with their new deal, which could still be re-refinanced in many cases (although he conceded that the value of an advance refunding option would probably push the mathematical theory beyond reasonable limits).

Kalotay said the resulting calculation, “refunding efficiency” is common in the taxable fixed-income markets. “It’s been done for mortgages for 30 years.  Why is it not being done for municipalities?”

One reason could be the continuing difficulty of obtaining accurate market data in the notoriously illiquid muni-market.  Kalotay, who made his first major foray into the tax-exempt sector as the pricing consultant who helped deliver the “constant valuation” model that made exchange-traded municipal bond funds possible, said he is not totally satisfied that the most widely used benchmark yield curves – from Thomson Reuters’ Municipal Market Data and Municipal Market Advisors – are as useful as the yield curves that can be observed in other markets.

But Kalotay said he thinks the root of the problem is simpler:  Issuers simply don’t ask their professionals for these analyses, and they’re rarely offered.

That inertia could also be behind the preference for tried and true bond structures, rather than term bonds that could offer investors more liquidity – and issuers a better price.  He contended that serial bonds are easier for dealers to sell.

“Liquidity has tremendous value – why fracture an issue into many serial bonds, when you can structure it as a term bond?” he asked. “Term bonds have all sorts of optionality:  If there’s liquidity, you can buy it back in the marketplace as a discount, rather than redeeming it at par, saving even more money.”

Notably absent from Kalotay’s discussion was any consideration of municipal issuers’ uniquely risk-averse posture – especially towards the possibility of losing out on current savings if the markets change – or arbitrage-rebate considerations.  But at a time when all of the old rules are being re-thought, it’s tough to argue with his call for issuers to demand more analysis from their professionals when entering into million-dollar deals.

-- Mike Stanton, Publisher