How much does a call option cost?

For well over a decade, the institutional municipal market has been dominated by high 5% bonds callable at 100 in year 10. The premium market price corresponding to the artificially high coupon virtually eliminates the ‘de minimis’ risk — high-grade 5% bonds are unlikely to ever trade below par. Due to their prevalence, the standard municipal yield curve is specified by the yields of 5% callable bonds.

Issuers routinely refund 5% bonds in year 10, and the resulting savings can be significant. It is notable that although refunding is typically associated with declining interest rates, 5% bonds are refunded even if rates rise. If in doubt, find 5% bonds over 10 years old.

The savings from refunding come at a hidden cost. Callable 5% bonds are effectively 10-year bonds, independent of their nominal maturity. Investors expect that the 5% coupon will last for only 10 years and extract a commensurate charge. Simply put, a 5% non-callable bond would be worth a lot more than one that is callable at par in year 10. We will explore how much more — the difference is the hidden cost of the call option.

Determining the fair prices of long 5% non-callable bonds is easier said than done, because such bonds don’t exist. In fact, even long muni interest rates are a mystery — yields to call are not interest rates. Fortunately, interest rates can be extracted from the standard callable yield curve, using readily available option-adjusted spread (OAS) analytics. All we need is to specify the interest rate volatility — the higher the volatility, the lower are the optionless rates. The sanity check for volatility is that the ratios of the resulting muni rates to like maturity Treasuries should gradually increase, to roughly 85% on the long end.

The table below displays recent AAA yields, along with the estimated muni interest rates, based on 17.5% volatility. The yield to call of the benchmark 30-year 5% bond was 4.39%, and our estimate of the 30-year interest rate is 4.03%. The concurrent 30-year Treasury yield was 4.77%; the resulting 86% muni to Treasury ratio (4.03/4.77= 86%) is reasonable.

Using these rates and the 17.5% interest rate volatility, we can easily calculate the fair price of any bond structure. The cost of the call option is the difference between the price of a non-callable bond and a callable bond of the given maturity. Here are selected option costs.

Let’s take a closer look at these results.

Based on its 4.39% yield to call, the price of a 30-year callable bond is 105. According to our calculation, the price of a 30-year optionless bond would be about 12 points higher, or roughly 117. Savings from refunding are less impressive once we recognize the significant upfront cost of the call option. Just to recover the 12 points upfront cost, the present value savings at the call date in year 10 would have to be at least 16 points, not including the transaction costs (underwriter, legal, advisory) that easily amount to well over a point.

Municipal issuers routinely call and refund 5% bonds in year 10, whether rates are higher or lower than they were initially. The upfront cost of the call option is an eye-opener in assessing the wisdom of issuing 5% bonds callable at par.

Unfortunately, municipal issuers tend to make funding and refunding decisions without paying attention to option values. There are superior alternatives to the par call in Year 10. The waste could be reduced by raising the call prices, so that refunding will result in savings only if rates are lower than they were at the time of issuance. Even better, consider issuing optionless bonds.