Modeling Municipal Yields with (and without) Bond Insurance
Forthcoming, Management Science
61 Pages Posted: 12 Oct 2015 Last revised: 30 Oct 2018
Date Written: May 30, 2017
We develop an intensity-based model of municipal yields, making simultaneous use of the CDS premiums of the insurers and both insured and uninsured municipal bond transactions. We estimate the model individually for 61 municipal issuers by exploiting the dramatic decline in credit quality of the bond insurers from July 2007 to June 2008, and decompose the municipal yield spread based on the estimated parameters. The decomposition reveals a dominant role of the liquidity component as well as interactions between liquidity and default similar to those modeled by Chen et al. (2016) for corporate bonds. Towards the end of the sample period, our model also reproduces the "yield inversion" phenomenon documented by Bergstresser et al. (2010).
Keywords: Municipal bonds; bond insurance; monoline; default risk; liquidity risk; term structure modeling
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