We see a lot of confusion in public finance as to how to analyze refundings. Unfortunately I think much of it stems from people outside of public finance coming in without a complete understanding of the environment in which a tax-exempt issuer operates i.e. the muni market. These interlopers get excited when they see option specifications in an official statement, then cry out, “We’ve seen these before. We have fantastic models used everywhere else, they must apply here too!” Unfortunately the foundational assumptions underpinning these models do not exist in the muni market leading this statement to be bunk (technical term my father used to use…). In fact those elegant bond options models do not apply in the muni flea market.
Let’s start with a simple assumption. While we're here it is very important to understand the assumptions of any financial model, particularly so with options. The complexity and elegance of the math involved in options can temporarily blind the most clear-thinking practitioner to the fact that important assumptions are just not satisfied in the muni market.
The assumption I make is simply stated but has far-reaching and critical implications for the right financial economic analysis for refundings:
An Issuer can ONLY achieve value from an optional redemption by performing an (advance or current) refunding
That is, the only way to lock in economics is to actually exercise the option. Some may argue that this is an extreme assumption. Ang et al in their irretrievably flawed paper on advance refundings take issue with this very topic, lamenting that issuers should more efficiently manage the undeniable interest rate risk in their optional redemptions by using derivatives. In the ivory tower they enjoy the luxury of ignoring patently unbalanced exposés like this one on Chicago Public Schools use of synthetic fixed-rate debt. Very real political considerations aside, suffice it to say that the number of states, munis, or tax-exempt entities comfortable with swap contracting and its attendant liquidity and credit risks is unfortunately very small. For the vast majority, swap is currently a four letter word.
So let’s assume the above statement for the moment; what are the ramifications? In short, it means the beautifully elegant models increasingly brought to bear on municipal optional redemption features do not apply. Option Adjusted Yield, lognormal short-rate models, no-arbitrate conditions – they don't work for munis. In an article on stock options discussing option owners who cannot sell, Paul Wilmott (himself a veritable LeBron James of financial engineering) puts it this way:
“In many situations, the only way of locking in the profit may be to exercise the option early. The ‘theory’ says don’t exercise, but if the stock does fall then you lose the profit. At this stage it is important to remember that the theory is not relevant to you [emphasis added].”
On Exercising American Options: The Risk of Making Too Much Money Ahn Hyungsok and Paul Wilmott, 2003
Issuers are in exactly the same spot. They can’t just sell their options. Nattering about the right volatility or mean reversion input to use in your standard bond option model (BK or BDT or the like) is a lot of misspent energy. As research has detailed recently, for many reasons above and beyond the simple one stated here, these are simply the wrong models for issuers to use to solve the refunding timing problem, which is a risk management problem if ever there was one.
So if we can’t use all that admittedly Nobel-worthy theory in analyzing refundings, what are we to do? In short, get real. Use a real-world market model of both issuer and SLGS yield curves, capturing the complicated way those two markets move. And with that real-world model in hand search for good, robust signals that help issuers decide when to refund. And do this by testing actual issuer refunding criteria: PV savings, escrow efficiency, the NYS/MTA table, the opportunity index used by the state of Wisconsin and any and all combinations thereof.
Two pieces of research do just that, by testing roughly 40 different refunding policies (read “signals”) both on a 50 year historical basis and prospectively on a simulated basis. One result that may surprise is that refunding efficiency (using one of those standard bond option models) doesn’t fare so well under the bright light of both historical and simulated performance. In fact, 100% refunding efficiency was ranked dead last among all policies. And lower percentage refunding efficiencies behave in practice a lot like the far simpler signal of 5-6% present value savings. More interesting, an Alternative Policy was identified, currently not in use to my knowledge, that trumps all others – and not by a little. More on this in future articles.
As the MSRB drafts its curriculum for educating municipal financial advisors, I hope the realities of the municipal market are kept front of mind when they cover options. They have the choice between propagating the mistakes currently happening far too often in the municipal market, or helping advisors and ultimately issuers understand the right types of analysis and models that apply and why. I’m crossing my fingers for the latter.