The US Municipal Bond Risk Model

Oren Cheyette
 THE US MUNICIPAL BOND RISK MODEL

Overview
Barra’s integrated risk model includes coverage of municipal bonds accounting for market-
wide and issuer-specific risks of investment grade municipal securities.

The municipal bond market is affected by financial factors somewhat distinct from the
primary drivers of the taxable bond market. Aside from the obvious different in tax
treatment, some other key differences are:

■ A very large number (about 2 million) of relatively small, illiquid issues

■ Additional option features, such as pre-refunding

The new model is designed with these differences in mind. Because of the large number
of illiquid bonds, estimation of market valuation factors is a job we believe better left to
muni market professionals. Therefore, unlike our approach in the taxable markets, where
we start with asset terms and prices, in constructing our muni model we start from vendor-
supplied sector yield curves. Our model is based on histories of four yield curves for
national general obligation (GO) bonds rated AAA (uninsured), AA, A and BBB1. Histories
of these yields back to 1994 are the basic information used in constructing the model.
1

The Muni Risk Model

The muni risk model structure is similar to— though simpler than— the taxable US model.
Like the investment grade portion of the taxable model, the dominant contribution to
risk arises from market-wide interest rate levels. These are captured in the muni model by
eight key rate factors, at the same maturities as for taxable interest rates: 1, 2, 3, 5, 7, 10,
20 and 30 years. Rather than following the usual practice of calculating spot rates from
yields by “bootstrapping”2, we calculate the current levels for the key rates by means of a
modified version of our standard spot rate estimation machinery, which minimizes root-
mean-squared pricing error of a universe of bonds. We do this because the practice for
reporting market yields for maturities beyond 10 years is to quote yields of callable bonds.
Were we to do standard bootstrapping, then use the resulting spot rate curve to value
callable bonds, we would not reproduce the market yields we started from. Figure 1 shows
estimated spot rates and corresponding market yields for 2/12/2001. The pronounced dip
in the 30 year spot rate is primarily due to the callability of the longer bonds.

In addition to the non-taxable interest rate factors, the model includes three credit spread
factors: one each for AA, A and BBB rated bonds. These are calculated as average spreads
of the corresponding spot rate curves over the AAA curve. Figure 2 shows estimated
muni credit spreads since 1994.

1
Yield curve data is supplied daily by Delphis-Hanover corporation.
2
Bootstrapping is a procedure for recursively calculating successively longer spot rates based on market yields.
Given an interpolation scheme for spot rates or yields between specified maturities, one can find, either analyti-
cally or numerically, the spot rates implied by the yields starting at the short end and working to longer maturities.

© BARRA 2001
 Figure 1

AAA GO Muni yield curve and Rate

estimated spot rates on 2/12/2001 5.5

5.0

4.5

4.0

3.5

3.0
0 5 10 15 20 25 30

Term (years)

Par Yields Spot Rates

2
Figure 2

Credit spreads for AA, A and BBB

rated GO bonds Spread (bp)

100

90

80

70

60

50

40

30

20

10

0
1/94 1/95 1/96 1/97 1/98 1/99 1/00 1/01

BBB A AA

It is interesting to compare the timeseries of Figure 2 with similar graphs of swap and
credit spreads in the taxable market. While the taxable credit spreads experienced huge
shocks in the second half of 1998, followed by persistently higher volatility and levels
continuing to the present, no such effect is visible even in the lower-grade muni spreads.
Over this period, at least, the muni market has manifestly behaved entirely independently
from the taxable market.

© BARRA 2001
 THE US MUNICIPAL BOND RISK MODEL

In total, then, the muni risk model contains 11 common factors: eight key rates and three
rating spreads. In addition to common factor risk, the muni model incorporates a modified
version of the taxable issuer credit risk model. Based on the Credit Metrics approach, the
issuer credit risk model uses historical information about credit migration rates together
with current spread levels to forecast risk due to up or downgrades and default. The
muni model uses the same credit migration rates as the taxable model—obtained from
Standard and Poor’s, these are historical averages of all issuer credit migrations.

Risk calculation for a bond portfolio requires not only estimates for factor volatilities and
asset-specific risks, but also estimates for the exposure of each bond to the risk factors.
The exposures to key rates are the key rate durations; the exposure to credit spread (for
bonds rated AA and below) is the spread duration.

For straight bonds with no embedded options these exposures are easily calculated by
means of standard formulas for discounted present value. However, not only are many
municipal bonds callable (and some putable), already necessitating use of a conventional
option model, but as noted above, many bonds carry in addition a so-called pre-refunding
option. This is the issuer’s option to defease an issue by creating an escrow account
funded by taxable Treasury securities to make remaining interest and principal payments 3
on an issue. This creates a tax arbitrage, whereby a municipality is able to convert taxable
Treasury bond payments into tax-free municipal bond payments. While the extent to
which municipalities can benefit from this arbitrage is constrained, yield curve slope
effects can nevertheless permit an issuer to realize savings by pre-refunding. Both the
issuer and the holder benefit from the exercise of this option. Defeasance is almost
always to the first call date.

Barra’s risk analytics provide calculation of option-adjusted spread, key rate durations,
spread duration and effective duration and convexity for refundable municipal bonds
accounting for the value of refunding along with the other conventional options.

Recent Results
Table 1 shows model forecasts as of 1/31/2001 for the muni interest rate and credit spread
factors and issuer credit risk. For purposes of forecasting common factor risk, muni bonds
rated below BBB are exposed to the BBB spread factor. Credit risk for such bonds is
modeled as for the others, by means of the credit migration model.

Table 1 Factor Factor Volatility Credit Risk

Common factor and issuer credit Muni Spot Rates 64 bp/yr 4.2 bp/yr
risk forecasts for municipal bonds Muni AA 8.5 10
as of 1/31/2001 Muni A 11 21
Muni BBB 14 47
Muni BB 97
Muni B 240
Muni CCC 540

© BARRA 2001
 Recent Treasury and swap rate volatility forecasts have been hovering around 80–90 bp/yr.
The first row of Table 1 indicates that muni bond interest rate volatility has been about
75% to 80% as large. This is perhaps slightly higher than the 60%–70% one might expect
based on taxable yield equivalence. Taxable credit spread volatilities, on the other hand,
appear to be considerably higher —by factors of 2 to 3 — than those for munis, as shown
in Table 2.3

Table 2 Factor Factor Volatility Credit Risk

Average common factor and issuer AAA 22 bp/yr 11 bp/yr

credit risk forecasts for taxable AA 27 26
corporate and sovereign bonds, A 31 38
as of 1/31/2001 BBB 37 92
BB 100 220
B 203 363
CCC 274 732

Figure 3 shows historical correlations (equivalently, the history of model forecasts)

between the muni AAA spot rates and muni credit spreads, US Treasury rates and the

4 swap spread. The large correlation between muni and Treasury rates is unsurprising— the
tax driven link between the markets would naturally be expected to play a large role for
the least credit-risky munis. The figure also shows that the other correlations are all near
zero. Muni AAA spot rates are nearly uncorrelated with muni credit spreads and with the
taxable swap spread.

Table 3 shows correlations between the swap spread and taxable credit spreads and
muni rates and spreads. The high correlation between swap spreads and the various tax-
able credit spreads is partly a result of the recent idiosyncratic behavior of the Treasury
market. However, the near zero correlation of the muni spot rates and credit spreads with
the swap spread indicates that municipal market pricing has been largely independent of
the turmoil in the taxable credit market.

Summary
The newly released municipal market risk model is designed to capture the dominant
contributors to market-wide and issuer specific risk in the tax-exempt US domestic
market. The eleven factors cover interest rates and common-factor spread risk for bonds
rated BBB and above, and issuer specific credit risk to CCC. Recent price movements in
the muni market suggest that it has been largely unaffected by the volatility of the tax-
able market subsequent to the 1998 credit crash.

3
The size of corporate spread volatilities is partly due to the recent decoupling of the Treasury market from the
credit markets, so this comparison somewhat overstates the difference between spread volatility in the taxable
and tax-exempt markets. However, the negative correlation between taxable spreads and spot rates has actually
been fairly low in recent months, so the impact of this decoupling is small.

© BARRA 2001
 THE US MUNICIPAL BOND RISK MODEL

Figure 3

Historical correlations
Correlation
(two year half-life) between muni
0.7
AAA spot rates and each of:
Treasury spot rates, muni AA, A 0.6
and BBB spreads, and the swap
0.5
spread over Treasuries.
0.4

0.3

0.2

0.1

0.0

-0.1

-0.2
12/98 6/99 12/99 6/00 12/00

BBB A AA Treasury Swap Spread

Table 3 Factor Group Swap Spread Correlation

Correlations between the US AGENCY 0.60

swap spread and other factors AAA 0.60
as of 12/31/2000 AA 0.51
A 0.57
BBB 0.52
BB 0.46
B 0.49
CCC 0.51
MBS 0.62
MUNI SPOT 0.19
MUNI AA 0.09
MUNI A 0.11

MUNI BBB 0.17

Summary
The newly released municipal market risk model is designed to capture the dominant
contributors to market-wide and issuer specific risk in the tax-exempt US domestic
market. The eleven factors cover interest rates and common-factor spread risk for bonds
rated BBB and above, and issuer specific credit risk to CCC. Recent price movements in
the muni market suggest that it has been largely unaffected by the volatility of the taxable
market subsequent to the 1998 credit crash.

© BARRA 2001