A municipal bond’s embedded call option allows the issuer of the bond to “call” (i.e., pay back) the debt at a date prior to the bond’s final maturity. This, in turn, potentially allows the issuer to reduce the cost of financing when interest rates decline – in the same manner that a homeowner might refinance a mortgage.
To compensate investors, bonds with embedded call options, known as callable bonds, are typically offered at higher yields than non-callable bonds. Callable bonds represent the majority of the municipal bond market. In fact, historically, roughly 85% of all municipal bonds issued over the past 20 years have featured call options.Footnote1
However, pricing callable bonds can be a tricky proposition – particularly municipal bonds. This can create opportunities for savvy bond managers and investors.
The MMD yield curve and pricing newly issued municipal bonds
The municipal market data (MMD) yield curve is the most widely referenced yield curve in the municipal bond market. For investors familiar with the U.S. Treasury yield curve, which quotes the yield to maturity (YTM) on non-callable Treasury bonds, the conventions of the MMD curve might seem unorthodox.
The benchmark bonds along the MMD curve reflect the standard for newly issued bonds in the municipal market, with some base assumptions:
- By convention, bonds carry a 5% coupon, although this can change.
- Bond maturities less than or equal to 10 years are non-callable.
- Maturities greater than 10 years have a 10-year lockout period, which means they are not callable for the first 10 years.
- Yield to maturity (YTM) is used for non-callable structures, while yield to call (YTC) is used for callable structures.
Given these assumptions, the MMD curve acts as a benchmark for determining how cheap or expensive a newly issued 5% coupon callable municipal bond (or non-callable bond under 10 years to maturity) appears relative to the broader market.
Pricing munis in the secondary market is more challenging
However, most bonds in the secondary market do not match the call and coupon assumptions of the MMD curve, which has led to the development of a municipal market convention of quoting yield spreads on a maturity-matched basis. Unfortunately for investors, this can lead to bond mispricing.
Let’s take, for example, a bond with 15 years to maturity and a seven-year lockout period (abbreviated as 15NC7). Because this bond’s first call date is in seven years, it has no direct comparison point on the MMD curve. (Recall that the MMD curve assumes the bond is not callable for 10 years.)
To adjust for this, a conventional market-spread pricing approach would match the 15NC7 with a 15-year maturity point on the MMD – in this case, a 15NC10 – and use the corresponding yield spread to quote the bond’s price.
Note that although the two bonds have very different structures (a 7-year first call versus a 10-year first call), they are priced as if they’re structured the same. The spread on the 15NC7 is calculated as the difference between its YTC and the 15NC10 MMD yield, which may or may not represent a true measure of its value, depending on the market environment. This may reflect either too much or too little value, since the bond is not being compared to a bond with the same structure.
Fortunately, we believe there’s a more accurate way to price municipal bonds.
The value of a quantitative approach
Using daily MMD yield and volatility measures, it is possible to calculate the MMD-implied yields on bonds of all call and coupon combinations using an interest rate and pricing approach. The resulting yield spread should provide a more accurate measure of the value of the bond.
Let’s take a closer look at how the two approaches differ.
Conventional vs. quantitative pricing
Consider the hypothetical example in Figure 1, which features a 15NC10 AAA municipal bond. According to MMD convention, the 15-year point on the MMD curve results in a YTC for a bond with 10 years to call – matching most newly issued bonds. After eight years, however, this municipal bond would be considered a 7NC2, since both its years until maturity (originally 15) and years to call (originally 10) have each decreased by eight years.
A conventional market-spread approach would determine the yield on the 7NC2 bond from the 7-year point on the MMD, even though the 7NC2 in question does not match the call and coupon assumptions of the MMD curve. In this example, the MMD-implied yield would be 2.07%.
PIMCO uses a more advanced quantitative approach that incorporates all call and coupon combinations, resulting in a YTC of 1.81% – 26 basis points lower than the 2.07% calculated using a conventional method.Footnote2 What a difference – and a potential opportunity to capitalize on what we believe is the bond’s mispricing.
Positioning municipal investors to benefit from opportunities in callable bonds
Working with a municipal bond manager with strong quantitative research capabilities and expertise in sourcing and valuing callable bonds may allow investors to harvest municipal bond market inefficiencies and generate additional yield.
Learn more about municipal bond markets and PIMCO’s investment ideas at pimco.com/munis.