The rush of state and local governments into the taxable bond market has prompted reports of significant savings. Just how much savings is a contentious - and complicated - question.
Issuers and financial advisers are touting the savings issuers have realized by selling Build America Bonds, which were authorized through the enactment of the American Recovery and Reinvestment Act in February.
This legislation enabled issuers to sell taxable bonds and receive a subsidy of 35% of the interest cost from the federal government.
So far, BABs after the federal subsidy have carried lower yields than the issuers' tax-exempt debt. Therefore, the issuers are saving money by accessing a new market with diverse classes of investors.
If only it were that simple.
In the tax-exempt market, local governments are accustomed to selling bonds with call options, which allow issuers to buy back their debt, usually after 10 years.
This embedded feature offers issuers the opportunity to refinance their debt and save money should interest rates decline, by raising new cash at a lower rate and paying off the bonds carrying a higher rate.
Investors in the taxable bond market are not so accustomed to this feature, and demand greater compensation to buy bonds carrying call options.
Several of the largest issuers selling BABs have opted to sacrifice call options rather than pay the higher premiums demanded in the taxable market. Yield premiums on callable debt over noncallable debt in the taxable bond market are often many times higher than the yield premiums for callable tax-exempt debt.
Some of the savings issuers are achieving by selling BABs stem from forgoing call options.
Take the New Jersey Turnpike Authority, which oversees 148 miles of highways and interchanges in the Garden State. Last month it sold $1.38 billion of Build America Bonds maturing in 2040 at a yield of 7.41%.
The authority at the same time issued $375 million of tax-exempt bonds, some of which mature in 2040 at a yield of 5.35%, callable in 2019.
This deal, underwritten by Morgan Stanley, provides direct comparison for financing costs in the tax-exempt and taxable markets.
The federal government will pay 35% of the coupon on the BABs, meaning the Turnpike Authority is effectively paying a yield of 4.82%. That means BABs offered the agency financing costs 53 basis points cheaper than tax-exempt bonds.
Well, not exactly.
The call option has intrinsic value. It confers flexibility and the opportunity to save money.
Some of those 53 basis points were shaved off by reaching new investors. Some were shaved off by relinquishing that option's value.
Just how much real value is lost determines how much the issuer is really saving through this new type of bond.
So what is the option worth? Perhaps not surprisingly, opinions vary.
The most obvious method to value the option is to measure the spread of yields on callable bonds over noncallable bonds in the tax-exempt market.
On this basis, call options have negligible value. According to the Municipal Market Data's triple-A yield curve, 30-year callable municipal bonds yield only three basis points more than noncallable munis.
One could say this is the "market value" for call options in the tax-exempt market.
Joseph Fichera, chief executive officer of Saber Partners, is skeptical of this method. To have faith this pricing is accurate, one would have to believe the muni market is completely efficient, Fichera said.
It is anything but.
In fact, investors in the tax-exempt market persistently underprice call options, according to Peter Coffin, founder of Breckinridge Capital Advisors in Boston. He avoids long-term callable munis for that very reason.
"You don't get paid enough as an investor for the call," Coffin said. "We won't buy long-term bonds because of the embedded calls. We kind of agree with the taxable market, that you don't get paid enough yield for what you give up."
Robert Nelson, an analyst at MMD, said that while the value of anything is what people will pay for it, the pricing of options in the tax-exempt market is sloppy.
"What we find in reality in tax-exempts is that the market remains inefficient and bonds trade at levels of perceived value regardless of any option analysis," Nelson said. "The valuation of the call option is so inefficient you're left to wonder, what is it really worth?"
Another way to look at it is, what is the value of the call to the issuer?
George Friedlander, managing director at Citi, believes issuers are valuing call options at 30 to 40 basis points.
The Turnpike thus might subtract 30 to 40 basis points from the 53 basis points of savings to calculate the real savings of selling noncallable BABs instead of callable tax-exempt paper.
Small wonder then that with tax-exempt yields down significantly since the first BABs came to market, "some issuers have begun to question whether they were willing to give up the right to call their long-term bonds," Friedlander said.
Since the mid-1980s, bond investors have developed increasingly sophisticated methods to price embedded options. Analysts in the bond market typically determine to what degree relinquishing the option slices the yield by measuring what they call an option-adjusted spread.
This involves analyzing a bond as a package of cash flows and options. In the case of a callable bond, an analyst would split the debt into separate features: a certain number of coupon payments, a principal payment, and a call option.
The coupons and principal have value to the bondholder; the call option has value to the issuer. In determining a fair price for the bond, the analyst would gauge the value of the coupon and principal, and then subtract the value of the call option.
Andrew Kalotay, president of Andrew Kalotay Associates, is an expert at this process.
He explains that his models quantify the value of a call option based on two main factors: the yield curve and interest rate volatility.
The yield curve, which graphs how interest rates ascend with longer maturities, matters because it depicts expectations of interest rates in the future.
Because issuers can only save money through a call option if interest rates decline, the option becomes more valuable with flatter or inverted yield curves - which communicate expectations for flat or lower interest rates in the future - and less valuable with steeper yield curves, which communicate expectations for higher rates.
Interest rate volatility matters because greater volatility makes it more likely interest rates at some point will breach the level at which it becomes beneficial for the issuer to exercise the call.
To measure the value of the call in the tax-exempt Turnpike deal, Kalotay assumed the interest rate volatility implied by callable and noncallable bonds in the agency bond market. The agency bond market - where bonds issued by government-sponsored enterprises like Fannie Mae and Freddie Mac trade - is more efficient and better at gauging interest rate volatility than the tax-exempt market, according to Kalotay.
Based on the implied volatility, his model plots the hypothetical path of interest rates over and over again, and sees how often the evolution of rates results in an environment in which the Turnpike would save money by calling its bonds.
His model determined the sacrificed call option was worth 3.1 "points," or $3.10 per $100 of par value.
In other words, for every $100 of par value in the tax-exempt deal, the Turnpike collected $100 in cash and $3.10 in optionality.
The yield to maturity on the tax-exempt debt plus a properly valued call option - essentially $103.10 par value instead of $100 - is 5.15%, Kalotay estimated, compared with the 5.35% yield on the bond.
Kalotay's model therefore suggests the Turnpike sacrificed a call option worth 20 basis points, and saved 33 basis points through BABs.
"What we have just done is the fair comparison," Kalotay said.
Dennis J. Enright of NW Financial Group in New Jersey has a more practical - and less complicated - way of looking at it.
Enright, who was financial adviser to the Turnpike on its BAB deal, said his client does not care so much what a model says an option is worth.
His client is a highway operator, not an options trader. What the Turnpike wants to know is, how likely is the option to result in savings, and how much?
While the modeled price of the option theoretically expresses this, Enright said Turnpike Authority officials have a more direct way of looking at it.
An issuer will usually exercise a call if it results in savings of 3% or more, Enright said. By selling in the BAB market without the call, he calculates the Turnpike saved 7.9% compared with the tax-exempt market.
The authority did not need the option to save money in the future - it saved money in the present, at more than twice the rate of savings issuers would hope for using a call option, according to Enright.
This is not some arcane concept relegated to a late chapter of a quantitative finance textbook.
BABs have bolstered the entire tax-exempt market because they promise to transfer supply from the tax-exempt market into the taxable market. If BAB yields descend to a level where issuers would prefer to keep the call, the issuance would leap right back to the tax-exempt market.
The value of the call option determines where that level is.
"We suspect that the reduction in muni yields resulting from the success of BABs may already have taken much of the attractiveness out of BABs for some issuers," Friedlander said.