Ask a municipal expert, "Instead of yield to worst, why don't you use standard analytics that are routinely deployed for corporate bonds and asset- backed securities?" The predictable response: 'Munis are different." And that somehow precludes the use of option-adjusted spreads.
At long last I have determined what makes munis profoundly different: it's the call feature. Outside the muni world, people believe that the call feature exists to allow the borrower to reduce interest payments when rates decline, by calling and refunding. Not so with munis; they are routinely refinanced even if interest rates rise!
That's because the system is designed to reward the issuance infrastructure – the underwriters, the lawyers, the advisers, everyone except the taxpayer. This system hinges on the issuance of turbocharged 5% bonds, callable at par in Year 10, that have become dominant in recent years. These bonds get refunded after 10 years, whether rates decline or increase. Normally refunding at a higher rate can be an unpleasant experience for the treasurer, but that is not the case with 5% callable bonds.
According to Bloomberg, on Aug. 25, 2016, the yield of a AAA 20-year 5% bond was 1.959% (127.49 price) and the yield of a like 10-year bond was 1.423% (133.23 price). To fund a 20-year project, one treasurer sold 20-year callable bonds, while another sold 10-year optionless bonds.
On Aug. 25, 2026, both bonds were refunded with 10-year bonds yielding 3.287% (114.50 price). The treasurer who originally sold 10-year bonds sheepishly acknowledged that, unfortunately, 10-year interest rates increased by 1.87%. The treasurer who issued 20-year bonds proudly reported that refunding at 3.287% saved 14.50% of the notional amount.
Something to consider.
