Call Options on Tax-Exempt Bonds Are Pricey

Virtually every longer-term tax-exempt municipal bond is callable, usually at par 10 years after issuance. Borrowers pay for the call option by an above-market coupon or at a reduced sale price. We explore how the value of the option compares to its cost.From the perspective of the municipal borrower, the valuation of the embedded call option on tax-exempt debt is surprisingly challenging. The source of the complexity is that the cost of tax-exempt debt depends on the borrower’s taxable rate, but the value of the call option also depends on the tax-exempt rate. Consequently, the analysis entails both taxable and tax-exempt rates. Is a fairly priced call option a good deal for the municipality? The remarkable finding is that the call option is an undesirable feature, because its cost exceeds its expected benefit. Instead of issuing callable bonds at lower prices or with higher coupons, municipal borrowers should consider issuing optionless bonds