Modeling Municipal Yields With (and Without) Bond Insurance

Abstract

We develop an intensity-based model of municipal yields, making simultaneous use of the credit default swap premiums of the insurers and both insured and uninsured municipal bond transactions. We estimate the model individually for 61 municipal issuers by exploiting the dramatic decline in credit quality of the bond insurers from July 2007 to June 2008, and decompose the municipal yield spread based on the estimated parameters. The decomposition reveals a dominant role of the liquidity component as well as interactions between liquidity and default similar to those modeled by Chen et al. [Chen H, Cui R, He Z, Milbradt K (2018) Quantifying liquidity and default risks of corporate bonds over the business cycle. Rev. Financial Stud. 31(3):852–897.] for corporate bonds. Toward the end of the sample period, our model also reproduces the “yield inversion” phenomenon documented in the literature. This paper was accepted by Neng Wang, finance.

"The Determinants of the Municipal Bonds Market in Romania"

“…They bring additional confidence in the issuers and lower risks. In addition, municipal bond yield is negatively related to insurance (Chun et al, 2019), which leads to a lower cost of borrowing. Credit ratings reflect the securities risks and investors rely on this information (Cornaggia, Cornagia and Israelsen, 2017); moreover, higher credit rating levels lead to lower demands for disclosure (Gillette, Samuels and Zhou, 2020).…”

Municipal Bond Insurance and the U.S. Drinking Water Crisis

“…Bond insurance is a form of credit enhancement where an insurance company commits to paying any shortfall in interest and principal owed on a municipal bond in case of municipal default. Bond insurance thus enables municipalities to raise debt at lower yields when investors view insurance as a valuable safety net against municipal default (Barkin, 2009;Chun et al, 2018;Cornaggia et al, 2021b). Thakor (1982) provides a theoretical model of bond insurance as a signalling device used by municipalities to credibly convey their (unobservable) credit quality to otherwise uninformed investors.…”

“…In 2007, the total debt raised by local municipalities for water infrastructure was $26.2 billion; 47.5% of this debt was insured. Several academic studies have further estimated that bond insurers can add value when they are of su ciently high credit quality, by allowing municipalities to o↵er bonds at lower yields than they would otherwise be able to o↵er (see Chun et al (2018) and Cornaggia et al (2021b)).…”

Municipal Bond Pricing: A Data Driven Method

“…For example, Wang et al (2008) introduces liquidity as an additional factor to the pricing model and studies the effect of systematic liquidity risk on the yields of municipal bonds. Chun et al (2018) regress the municipal bond yields on the Credit Default Swaps (CDS) premiums of the insurers. They discover that the liquidity component plays a dominant role in the composition of yield spread.…”