Analysis of the Call Feature on Municipal Debt.

• Author: Stock, Duane
• Position: Statistical Data Included

Including a call option in a municipal bond issue can have a significant impact on interest costs. This article discusses the circumstances that lead to higher interest rates for bonds with call features, and it attempts to aid issuers in deciding when to include a call feature.

The features of a bond issue have a very significant impact on the cost of borrowing, and the list of choices an issuer must make with respect to bond features is long and complex. For example, a bond issue can be variable rate or fixed coupon, and it may or may not contain a sinking fund. Further, some municipal debt is taxable while most is not.

This article will focus on the call feature, which allows the issuer to redeem outstanding bonds prior to their stated date of maturity at a specified price. It will present an analysis of the impact a call feature can have on the interest cost of a municipal bond issue, and based on this analysis, it will attempt to aid issuers in deciding whether or not to include a call option.

Recent advances in the modeling of options on debt instruments permit precise calculations to predict the impact of a call option, depending on market conditions and details of the call and the bond itself. The next section provides discussion of the factors that may influence the decision to include a call and some helpful tips for making the decision. The following section will discuss how the value (and yield) of a callable bond differs from a noncallable bond. Using a well-known option pricing model, the final section will provide actual computations of how many more basis points a callable issuer should expect to pay over a noncallable issuer. It will be shown that when aspects of the call and market conditions lead to a large value for the call option, small changes in any factor can have a large impact on the spread between callables and noncallables.

Costs and Benefits of a Call Feature

The decision to include or not include a call feature depends on several factors. In the final analysis, the decision is based on the likelihood of a number of events that are difficult, if not impossible, to forecast. The issuer must decide if the probabilistic benefits of including the call outweigh the costs. The most obvious benefit is the ability to refund the debt at a lower rate if interest rates decline. One can quantify the savings if interest rates decline, but the issuer has no sure way of knowing if interest rates will decline and, furthermore, cannot know how much they will decline.

Nonetheless, let us start with some of the most obvious and commonly cited reasons for corporate issuers of debt to include a call, where the same logic may be applied to municipal bonds. In corporate finance theory, an issuer will be more likely to include a call if interest rates are comparatively high at issuance and the corporation expects a strong likelihood of a future decline in rates that will make exercising the call profitable. A difficulty with this is that many academics and professionals believe that the market for debt instruments is quite efficient, which implies that the "buy" side of the market has similar expectations that interest rates are likely to decline, and they will demand that the issuer pay out a higher yield for the right to call. That is, the issuer cannot reap the benefits of the strong likelihood of a decline in interest rates and subsequent call without paying for it up-front in the form of greater interest costs.

Another reason for the inclusion of a call feature in corporate finance is to reduce the cost of asymmetric information. Assume that a firm has strong positive information about its prospects that it cannot credibly signal to the market. In such a case, the firm will be forced to issue bonds at a greater interest cost than justified by its true prospects, but it can include a call feature to hedge. Later, when the strong prospects are realized, the firm can call the bonds and replace them with debt that reflects its improved credit quality and allows lower interest costs on the replacement debt.

Although the theory of municipal debt call inclusion has not been modeled to the same degree as corporate bonds, the same principles can be applied. Municipal bond issuers may be more inclined to include calls if interest rates are high by historical standards and expected to decline. Also, if the municipal issuer thinks that the market is requiring too great a yield to be consistent with the credit quality and future prospects of the issuer, a call can make favorable refunding at a later date quite easy. For example, the issuer may include a call option if they expect development in the area to greatly enhance the tax base and revenue...