The Right and Wrong Models for Evaluating Callable Municipal Bonds

Abstract

Fixed rate municipal bonds are often sold with an optional redemption feature giving issuers the right to call the bonds prior to maturity. The application of no-arbitrage bond option models to help assess the value of these optional redemption features though not common has been increasing. Despite the availability of these models, widespread public finance industry adoption has not occurred. This paper outlines theoretical and practical problems with no-arbitrage models employed for the purpose of analyzing embedded options in municipal bonds. We also highlight recent research in yield curve modeling and show an example of a real-world approach to analyzing municipal bond options which introduces the concept of expected present value (EPV) savings.

Keywords: public finance, municipal bonds, municipal bond options, yield curve, term-structure model, Monte Carlo simulation