Kalotay cites higher muni costs, need for MA training due to advance refunding halt
WASHINGTON — The termination of advance refundings has raised the cost of municipal financing by about three basis points and brought more complexity to the bond market that necessitates additional training of municipal advisors, according to fixed-income expert Andrew Kalotay.
Kalotay’s findings appear in a paper, “Life Without Advance Refunding,” that is scheduled to be delivered here on Monday at Brookings Institution's 7th annual Municipal Finance Conference.
“There’s a loss of value to municipalities because the cost of debt will be higher," Kalotay said in an interview. Although three basis points "doesn’t seem like much,” he said, “in the big picture it will be significant.”
The loss of advance refundings will have a "staggering effect" on the market, he wrote in the paper.
He said that until this year, many muni bonds were aimed at institutional investors and had coupons above 5% and 10-year call dates. They would often be advance refunded before the call.
With the loss of advance refundings, calls will be shorter and coupons of less than 5% are likely to emerge. New benchmark curves will be needed to account for the new structures, Kalotay said in the paper.
“You always hear people say muni bonds are different, but in my opinion it’s just an excuse for not doing the right thing,” Kalotay said.
He faults the Municipal Securities Rulemaking Board and U.S. Securities and Exchange Commission for not requiring training in options-based analytics as part of their certification of municipal advisors.
“The so-called option-adjusted spread (OAS) methodology has been around since the mid 1980’s and it's hard to understand why municipal debt managers have largely disregarded it, in favor of questionable seat-of-the-pants methods,” he wrote in the paper.
“There’s an increasing need for analytic expertise,” he said. “Because once you have different coupons and lockout periods, different call periods, you cannot price everything off a standard 5% non-call  curve.”
Some issuers already have shortened call dates to less than 10 years and lowered coupons below 5%.
Municipal finance officials from Hennepin County, Minn., and Contra Costa County, Calif., were among several officials at the Government Finance Officers Association annual meeting in May who said the call date on new bonds had been reduced from the traditional 10 years.
“Bonds with shorter calls have been around in the taxable markets; many corporate bonds are callable in five years, and agency bonds are sometimes callable in less than a year,” the paper said. “Shorter calls are particularly desirable for asset-liability management of financial institutions. Make-whole calls will also gain popularity. Many Build America Bonds contained a make-whole provision, instead of a conventional call. Make-wholes enable issuers to retire bonds prior to maturity or conventional call date, but they are unlikely to provide interest savings. They cost little, and they provide commensurately low value.”
George Friedlander, managing partner of Court Street Research Group, responded to Kalotay's paper, writing in his newsletter Wednesday that issuers have found no advantage using either shorter call protections or lower coupons.
“The demand side of the market, even adjusted for the changes under tax reform, continues to be willing to pay a premium on the traditional 10-year call, 5%-coupon paper than they are on deals with shorter calls or lower coupons,” Friedlander wrote. “Without investor willingness to accept the new structures we do not expect that issuers will find the new structures advantageous.”
Kalotay, however, said he hasn’t taken a position on how common shorter call dates and lower coupon rates will be.
“Let’s put it this way,” he said. “Until the change in the tax law there were virtually no institutional issues with coupons other than 5%. And there already have been some and there will be more. So it’s a major change in that sense. But we’ll see. I think that the jury is out. Maybe that’s the best way to put it.”