Early redemption of tax-exempt bonds by taxable bonds is the dominant activity on municipal markets. This is the main driver of the increase in taxable volume. According to a recent report published in The Bond Buyer, taxable ammunition is now an “accessory, not a fad”. More and more frequently, these taxable ammunition receive a nominal call of 10 years. As will become clear, they are a good deal for investors.
Taxable bonds are issued to block savings – currently, the taxable borrowing rate for high-quality municipal issuers is well below the typical 5% coupon of outstanding non-tax-exempt bonds not yet due. The tax-exempt rate is even lower, but the 2017 Tax Reduction and Jobs Act removed the possibility of advancing repayment with another tax-exempt obligation. The reason for including the appeal clause in refundable taxable bonds is that they could potentially be redeemed with tax-exempt bonds.
How does the appeal clause affect the value of taxable ammunition? Normally, the value is determined using an OAS calculator, based on credit volatility and issuer-specific interest rates. This approach can also determine the fair coupon for a new redeemable bond, such as a 30-year NC-10. For example, when the rate of taxable ammunition without option AAA over 30 years is 2.80% (as it was the case at the end of February), the right coupon of a bond by 30 NC-10 with a volatility of 15% turns out to be 3.05%, or 25 basis points above the rate with no options. The 25 basis point spread is actually consistent with current prices. Similarly, the coupon for a 20 NC-10 is approximately 2.75%, or 13 basis points compared to the current 20-year no option rate of 2.62.
As we can see above, the “tax-exempt” redemption function does not affect the market perception of the value of the refundable taxable bonds. But in fact, it can generate a boon for investors.
Standard analysis assumes that the issuer of a taxable bond will exercise the call option optimally, based on taxable redemption rates. And the best time for the issuer happens to be the worst for investors. But in the case of taxable callable, the issuer can tap into the tax-exempt market to repay. Obviously, tax-exempt rates are always lower than taxable rates. For example, at the end of February, when the AAA long option taxable rate was 2.80%, the similar exemption rate was around 2.30%, or 50 basis points lower. Because of this difference between exempt and taxable rates, a taxable bond can be called when it is sold at a discount, as shown below. It goes without saying that investors would be more than happy with such calls.
To see this, let’s quickly go to the initial call date of our 3.05% 30 NC-10 bond, with 20 years left to run. Suppose the 20-year tax exemption rate has increased to 2.70%. The issuer should call its 3.05% taxable bond and replace it with a tax-exempt bond. What would it look like for the holder of the 3.05% taxable bond? Assuming that the 20-year taxable rate has also increased from 2.62 to 3.00%, the price of 3.05% callable the obligation is around 96.4, or 3.6 points below par. A discount bond called an au pair is a boon for the investor!
There are many scenarios of exempt and taxable rates where it makes sense for the issuer to call a taxable bond selling below par. The potential windfall for investors can be quantified by option-based analyzes. The results for a taxable bond of 30 NC-10 and 20 NC-10 are presented in the figure below. The expected benefit to investors depends on the spread between exempt and taxable rates from the issuer – the wider the spread, the greater the likelihood of “ineffective” calls and the greater the bargain for the investor is tall. At 30 basis points, the windfall on a 30 NC-10 is approximately 1.2 points, at 50 basis points it is approximately 2.3 points. In the case of a 20 NC-10, the windfall is smaller, but still important. At 30 and 50 basis points, the respective benefits are 0.3 and 1.1 points.
In summary, taxable taxable ammunition offers hidden value to investors. We have quantified this value for newly issued bonds, redeemable in 10 years. But what about seasoned bonds, or bonds with, say, a five-year roll call? The purchase decision depends on the tax-exempt rates of the issuer, while the value of the bond for the investor depends on the taxable rates. Identifying hidden value requires complex option-based analyzes – a challenge for the buying side.