Analysis of Municipal Refunding

Policies: A 50 Year Historical

Approach

Peter Orr
David de la Nuez
Intuitive Analytics LLC
(Working Paper, ver 12/10/2014)

We greatly appreciate the contributions of Municipal Market Advisors and Delphis Hanover Corporation
for municipal yield curve data used in this paper. Any errors are entirely our responsibility.

2014 Intuitive Analytics LLC. All rights reserved. Short sections of text, not to exceed two paragraphs, may be
quoted without explicit permission provided that full credit is given to the source.

Electronic copy available at: http://ssrn.com/abstract=2431267

ABSTRACT
The most common tax-exempt fixed-rate bond series structure in the $3.7 trillion US taxexempt bond market includes callable debt for maturities greater than ten years. The
decision as to when to refund (refinance) these bonds to generate interest cost savings is
an important one historically manifested by the use of various heuristic criteria. Some
municipal issuers codify these criteria and formally adopt them into what is commonly
called a refunding policy. In this paper we evaluate the performance of 38 refunding
policies through the lens of history. Using municipal and Treasury yield data dating to
1965, we calculate realized present value savings from various refunding policies.
Among the dozens of policies examined, a single, novel policy stands alone in realizing
significantly greater present value savings than any others.

KEYWORDS: Refunding, Municipal Bonds, Tax-exempt, Public Finance, Yield Curve,

Options

Electronic copy available at: http://ssrn.com/abstract=2431267

1. Introduction
Of the $3.7 trillion in municipal and tax-exempt bonds outstanding1, approximately $1.56
trillion2, or 41.6%, are long-term, fixed-rate, unrefunded and subject to redemption prior to maturity at the
option of the issuer. These optional redemption features have been in use for decades. Research on the
topic is sparse. Some have made the argument that taking the ratio of present value savings to the value of
the embedded option in the bond from a standard bond option model is a good decision criterion for
refunding.3 However others have pointed out that using standard option models are predicated on
assumptions that do not exist in the municipal market, and are inappropriate.4 Others have suggested that
advance refunding in particular is always a loss to the issuer.5 However this presumes that the option
could be stripped and sold in some sort of efficient options market. Again, this is not the case for
municipals.
In this paper we evaluate 38 policies involved in timing the refinancing bond issues employed to
take advantage of these call features. Until now there has not been, to our knowledge, a suitable
framework for testing the performance of refunding policies either prospectively, looking into an
uncertain future, or even retrospectively, judging performance by looking at historical data. As described
in (Orr and de la Nuez, Towards a Better Policy: Analyzing Municipal Refundings using a Real-World
Market Model 2014), the problem with standard no-arbitrage bond option models results from the nonexistence of a risk-neutral measure due to the incompleteness or non-existence of underlying options
markets.
In this paper we evaluate refunding decision criteria using techniques developed while
implementing a new, real-world market model, as appropriate for municipalities who are naked long the
optimal redemption feature. We apply a methodology originally created for analyzing the performance of

Source: Report on the Municipal Securities Market, U.S. Securities and Exchange Commission
Source: Bloomberg, October 29, 2013
3
See (Kalotay, Yang and Fabozzi, Refunding efficiency: a generalized approach 2007)
4
See (Orr and de la Nuez, The Right and Wrong Models for Evaluating Callable Municipal Bonds 2013)
5
See (Ang, Green and Xing, Advance Refundings of Municipal Bonds 2013)
2

refunding policies prospectively over thousands of simulations using a single path, that of nearly fifty
years of actual municipal yield curve history.
3. A Universe of Hypothetical Bonds
We begin our analysis by looking first at the single simulation available to us known as history.
We investigate the performance of various refunding criteria using tax-exempt and SLGS yield curve data
dating to February 3, 1964, by executing the following analysis on a monthly basis beginning on this first
date for which we have historical rate data. We consider a universe of continuously callable bonds with
first call dates varying from zero (i.e. currently callable) to ten years from the analysis start date in one
year increments. For each call date there are bonds with one to twenty years after the call date remaining
to maturity, also in one year increments; a total of 220 bonds. Figure 1 shows the maturity distribution of
these bonds.
Figure 1

Using the historical tax-exempt rates on the analysis start date for the three month and 1, 2, 3, 5,
7, 10, 12, 15, 20, and 30 year tenors, we linearly interpolate and round down to the nearest 12.5 basis
Table 1 Sample Refunded Bond Portfolio

1
2
3
4
5
6
7
After Call 8
to Maturity 9
10
11
12
13
14
15
16
17
18
19
20

0
4.125
4.250
4.500
4.625
4.625
4.625
4.625
4.625
4.625
4.625
4.750
4.750
4.750
4.750
4.875
4.875
4.875
4.875
4.875
4.875

1
4.250
4.500
4.625
4.625
4.625
4.625
4.625
4.625
4.625
4.750
4.750
4.750
4.750
4.875
4.875
4.875
4.875
4.875
4.875
4.875

2
4.500
4.625
4.625
4.625
4.625
4.625
4.625
4.625
4.750
4.750
4.750
4.750
4.875
4.875
4.875
4.875
4.875
4.875
4.875
4.875

3
4.625
4.625
4.625
4.625
4.625
4.625
4.625
4.750
4.750
4.750
4.750
4.875
4.875
4.875
4.875
4.875
4.875
4.875
4.875
4.875

Years to call
4
5
6
4.625 4.625 4.625
4.625 4.625 4.625
4.625 4.625 4.625
4.625 4.625 4.625
4.625 4.625 4.750
4.625 4.750 4.750
4.750 4.750 4.750
4.750 4.750 4.750
4.750 4.750 4.875
4.750 4.875 4.875
4.875 4.875 4.875
4.875 4.875 4.875
4.875 4.875 4.875
4.875 4.875 4.875
4.875 4.875 4.875
4.875 4.875 4.875
4.875 4.875 4.875
4.875 4.875 5.000
4.875 5.000 5.000
5.000 5.000 5.000

7
4.625
4.625
4.625
4.750
4.750
4.750
4.750
4.875
4.875
4.875
4.875
4.875
4.875
4.875
4.875
4.875
5.000
5.000
5.000
5.000

8
4.625
4.625
4.750
4.750
4.750
4.750
4.875
4.875
4.875
4.875
4.875
4.875
4.875
4.875
4.875
5.000
5.000
5.000
5.000
5.000

9
4.625
4.750
4.750
4.750
4.750
4.875
4.875
4.875
4.875
4.875
4.875
4.875
4.875
4.875
5.000
5.000
5.000
5.000
5.000
5.000

10
4.750
4.750
4.750
4.750
4.875
4.875
4.875
4.875
4.875
4.875
4.875
4.875
4.875
5.000
5.000
5.000
5.000
5.000
5.000
5.000

points to create discounted coupon rates for the bonds, slight discount pricing. An example from 1992 is
shown in Table 1. We also consider premium coupons for the bonds by adding 100 basis points to the
coupons in the discount case. On a monthly basis we then use the ensuing historical rates to create a
single simulation path of rates at each of the aforementioned tenors. Similarly we create a single path
for SLGS rates using the same tenors as for the tax-exempt rates with the addition of a six month tenor.
Thus at monthly intervals we have the necessary ingredients to calculate the present value of the savings
generated for the issuer by a potential refunding of each of the bonds that remains outstanding, in addition
to other quantities that are needed to apply myriad refunding decision criteria.
The simplest, and perhaps most commonly used refunding criterion is a comparison of the present
value savings of a refunding against a simple threshold, typically expressed as a percentage of the
refunded par, often in the range of 3-6%. That is, applying such a criterion, if the calculated savings
exceed the specified threshold, the option is exercised. Additional criteria used in our analysis are
described in Appendix A. Refunding policies are constructed from a combination of logical combinations

of refunding criterion and a review of issuer policies in practice (e.g. refund if present value savings
exceeds 3% and the escrow efficiency exceeds 90%).
4. Simulation #1 Historical Performance from 1965
The bulk of the remainder of this paper reviews results of applying forty different refunding
policies to our universe of hypothetical bonds. In order to compare policies, for both the discount and
premium bond cases, the aggregate present value savings generated (over all 220 of the bonds) by each
policy is used to measure the performance of the policies. The methodology for any given policy is as
follows as follows:
1. Starting at each hypothetical issue date, calculate on a monthly basis for each
bond if the policy indicates that the refunding should be executed
2. Present value the savings monthly per bond and per refunding policy, to the
hypothetical refunding date
3. Further present value the savings to the original issue date of the hypothetical refunded bonds
4. Sum present value savings of all bonds, per policy, on each issue date
5. Average to compare performance against other policies over time
Crucially, discounting is done with realized historical tax-exempt short rates6, neatly sidestepping any debate on the right or wrong way to discount. Specifically, we use the three month rate
as a proxy for the one month rates needed for monthly discounting. Figure 2 presents a comparison of
using the simple 3% Savings Percentage policy (solid red line) against using the 5% Savings Percentage
policy (solid green line) on our set of discount bonds, with the portfolio average coupon overlaid for
reference (solid shaded line with green for low rates, turning red as rates peak). It shows the performance
6

See http://www.intuitive-analytics.com/blog/bid/59515/HELP-Can-SOMEONE-Calculate-Refunding-PV-Savings
for a discussion on the difficulties of choosing a method for discounting for prospective analysis.

of the two policies across hypothetical issue dates ranging from January 1965 through December 2008.
Time runs along the horizontal axis, while the overall portfolio performance as described above is
measured along the vertical axis. On average the 5% policy outperformed the 3% policy as indicated by
the average savings across time (green and red dashed lines, respectively).
Figure 2 Refunding Policy Performance Comparison Discount Bonds, Jan 1965 Dec 2008

Figure 3 shows a comparison of a number of other common policies, in addition to the 3% and 5%
Savings Percentage policies. Here there is no clear winner among the various policies. The conclusion is
much the same for the same policies applied to the premium bonds over the same time horizon as seen in
Figure 3 Refunding Policy Performance Comparison Discount Bonds, Jan 1965 Dec 2008

Figure 4, with no single policy dominating the rest.

Figure 4 Refunding Policy Performance Comparison Premium Bonds, Jan 1965 Dec
2008

3. The Great Monetary Experiment: Before and After

The United States is now at the end of a single macroscopic interest rate cycle, where rates rose
steadily from the 1960s to the inflationary late 1970s and early 1980s, followed by a period of gradual
decline in yields ever since that time. A natural question to ask when testing the performance of
traditional refunding policies is, How do the policies perform relatively in rising and falling rate
environments? To answer this question we applied the methodology for the period from January 1965
through January 1980, and separately from February 1980 through the end of our horizon, December
2008, thereby capturing the rising and falling parts of the cycle.
Unsurprisingly, the results in Table 2 (sorted by the full period performance) show that in the
overall rising rate environment, none of the policies applied to discount bonds performed as well as they
did in the falling environment; as rates fall there are greater refunding opportunities. Also intuitive is the

performance of the refunding policies on the premium bonds in Table 3. As they are issued at a full 100
basis points above the prevailing market, one would expect refunding opportunities even as rates begin to
rise. Consequently, the results are more consistent across rate environments than they are for the discount
bonds.

Table 2 Refunding Policy Performance Comparison Discount Bonds, Jan 1965 Dec 2008
Refunding Policy
5% Savings
85% Refunding Efficiency
NYS / MTA Table
3% Savings
3% Savings, 95% Escrow Eff

PV Savings
PV Savings
PV Savings
Full Period 1/65 thru 1/80 2/80 thru 12/08
3.3%
1.2%
4.4%
3.1%
1.1%
4.1%
2.5%
1.4%
3.0%
2.4%
1.0%
3.1%
2.4%
1.0%
3.1%

Avg Years
to Refund
5.1
6.3
6.7
5.6
5.8

Table 3 Refunding Policy Performance Comparison Premium Bonds, Jan 1965 Dec 2008
Refunding Policy
85% Refunding Efficiency
5% Savings
3% Savings
3% Savings, 95% Escrow Eff
NYS / MTA Table

PV Savings
Full Period
5.2%
5.1%
4.5%
4.5%
4.5%

PV Savings
1/65 thru 1/80
4.4%
4.7%
4.7%
4.7%
4.9%

PV Savings
2/80 thru 12/08
5.6%
5.3%
4.4%
4.5%
4.4%

Avg Years
to Refund
2.2
2.1
1.2
1.2
0.7

In addition it should be noted that the premium coupon bonds in general generate greater savings
than the discount bonds in both rising and falling rate environments, as there is greater future interest
expense to recover through refunding of bonds with the larger coupons. For the premium bonds the
shorter time needed to reach a refunding opportunity that one would expect is demonstrated by the
significantly lower average time to refunding the final column of Table 3.

4. The Search for an Alternative

In (Orr and de la Nuez, Towards a Better Policy: Analyzing Municipal Refundings using a RealWorld Market Model 2014) the authors used an implementation of a real-world market model with both
borrower and escrow yield curves, based on the work in (de Guillaume, Rebonato and Pogudin 2013), to
prospectively test the performance of refunding policies under various conditions, and optimize the
parameters of policies to achieve improved expected present value savings. It was in doing this testing
and parameter optimization that an Alternative Policy was discovered which performed remarkably well;
so well that we were compelled to test it and other policies on the one great simulation path of history. 7
Those results are presented here, and to our great satisfaction the historical performance of the Alternative
Policy was equally impressive. Though the Alternative Policy does not perform better than all other
policies in all environments, the gains when it outperforms are far greater than its losses when it
underperforms. Figure 5, Figure 6, Table 4 and Table 5 show previous results with the addition of the
performance of the Alternative Policy. As indicated in Figure 5 and Figure 6, starting in the early 1980s
the Alternative clearly dominates all other policies, after performing unremarkably versus other policies
until that time. In the early period from 1965-1980, the Alternative Policy underperforms but by
relatively little in absolute terms, as seen in Table 4 and Table 5. But it utterly dominates the other
policies in the period from 1980 to 2008.
The Alternative Policy is a combination of two criteria. The first is a simple present value savings
threshold of 0.25%, far lower than those used commonly in practice. The other is a discrete option
sensitivity measure determined by calculating the percentage increase in present value savings resulting
from a parallel decrease in the issuers borrowing yield curve 25.6

Details on the implementation of the Alternative Policy can be found in (Orr and de la Nuez 2014).

Figure 5 Refunding Policy Performance Comparison Discount Bonds, Jan 1965 Dec 2008

10

Figure 6 Refunding Policy Performance Comparison Premium Bonds, Jan 1965 Dec
2008

Table 4 Refunding Policy Performance Comparison Discount Bonds, Jan 1965 Dec 2008
Refunding Policy
5% Savings
85% Refunding Efficiency
NYS / MTA Table
3% Savings
3% Savings, 95% Escrow Eff
Alternative Policy

PV Savings
Full Period
3.3%
3.1%
2.5%
2.4%
2.4%
5.6%

PV Savings
1/65 thru 1/80
1.2%
1.1%
1.4%
1.0%
1.0%
1.0%

PV Savings
2/80 thru 12/08
4.4%
4.1%
3.0%
3.1%
3.1%
8.0%

Avg Years
to Refund
5.1
6.3
6.7
5.6
5.8
8.8

Table 5 Refunding Policy Performance Comparison Premium Bonds, Jan 1965 Dec 2008
Refunding Policy
85% Refunding Efficiency
5% Savings
3% Savings
3% Savings, 95% Escrow Eff
NYS / MTA Table
Alternative Policy

PV Savings
Full Period
5.2%
5.1%
4.5%
4.5%
4.5%
7.3%

PV Savings
1/65 thru 1/80
4.4%
4.7%
4.7%
4.7%
4.9%
3.7%

11

PV Savings
2/80 thru 12/08
5.6%
5.3%
4.4%
4.5%
4.4%
9.3%

Avg Years
to Refund
2.2
2.1
1.2
1.2
0.7
5.7

5. Approaching Perfection
An advantage of back testing with historical data is that we can at any point in time determine
when a hypothetical refunding is optimal, or best performing policy would exercise, as well as calculate
the savings such a policy would generate. This is akin to what in the field of computer science is called
competitive analysis of online algorithms.8 An online algorithm, in short, is an algorithm that must make
decisions without knowing the future. Refunding policies thus can be viewed as online algorithms.
Competitive analysis, the study of the performance of online algorithms, involves comparing the
algorithm at hand, which does not have perfect information about the future, with a hypothetical best
offline algorithm that has perfect knowledge of the future.
It is in this context that we conceived the idea of comparing the performance of our suite of
policies, including the Alternative Policy, against the imaginary perfect timing (i.e. optimal or best
offline) policys performance. Figure 7 shows in thick blue lines for each of four policies the percentage
of the optimal policys performance that is captured at a given hypothetical issue date. The thin black
lines show the percent captured by the best of our suite of real, implementable policies at a given point in
time. Figure 7, in a striking way, shows how the Alternative Policy dominates other policies: the
Alternative Policy coincides with the best of our realizable policies from approximately 1980 and
forward, and before 1980, demonstrates how the Alternative Policy is able to capitalize on refunding
opportunities even when rates trend upward.

See, for example, (Sleator and Tarjan 1985), the classic paper on the list update problem.

12

Figure 7 Capture of Perfect Timing, Premium Bond Case

A comparison of performance of all the tested policies is shown in Table 6 and Table 7.

13

Table 6 Performance of All Policies, Discount Bonds

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.
24.
25.
26.
27.
28.
29.
30.
31.
32.
33.
34.
35.
36.
37.
38.

Slight Discount Bonds

Policy
Total
Perfect Timing
9.4%
Alternative Policy
5.2%
5% Savings, 100% Escrow Efficiency
3.5%
6% Savings
3.5%
90% Refunding Efficiency
3.3%
25bps Savings, 20% NegArb/Savings
3.2%
25bps Savings, 50% NegArb/Savings
3.2%
25bps Savings, 75% NegArb/Savings
3.2%
25bps Savings, 90% NegArb/Savings
3.2%
3% Savings, 20% NegArb/Savings
3.2%
3% Savings, 50% NegArb/Savings
3.2%
3% Savings, 75% NegArb/Savings
3.2%
3% Savings, 90% NegArb/Savings
3.2%
5% Savings
3.2%
5% Savings, 50% Escrow Efficiency
3.2%
5% Savings, 60% Escrow Efficiency
3.2%
5% Savings, 70% Escrow Efficiency
3.2%
5% Savings, 80% Escrow Efficiency
3.2%
5% Savings, 90% Escrow Efficiency
3.2%
5% Savings, 95% Escrow Efficiency
3.2%
3% Savings, 50% Delta
3.0%
85% Refunding Efficiency
2.9%
25bps Savings, 50% Delta
2.9%
4% Savings
2.8%
25bps Savings, 20% Delta+
2.8%
25bps Savings, 50% Delta+
2.8%
3% Savings, 20% Delta+
2.8%
3% Savings, 50% Delta+
2.8%
3% Savings, 100% Escrow Efficiency
2.8%
95% Refunding Efficiency
2.4%
NYS / MTA Table
2.4%
3% Savings, 95% Escrow Efficiency
2.3%
3% Savings
2.3%
3% Savings, 50% Escrow Efficiency
2.3%
3% Savings, 60% Escrow Efficiency
2.3%
3% Savings, 70% Escrow Efficiency
2.3%
3% Savings, 80% Escrow Efficiency
2.3%
3% Savings, 90% Escrow Efficiency
2.3%
100% Refunding Efficiency
1.8%

14

1/65-1/80
2.9%
1.0%
1.2%
1.2%
1.1%
1.2%
1.2%
1.2%
1.2%
1.2%
1.2%
1.2%
1.2%
1.2%
1.2%
1.2%
1.2%
1.2%
1.2%
1.2%
1.3%
1.1%
1.3%
1.2%
1.2%
1.2%
1.2%
1.2%
1.0%
0.9%
1.4%
1.0%
1.0%
1.0%
1.0%
1.0%
1.0%
1.0%
0.8%

1/80-12/08
12.4%
7.1%
4.6%
4.6%
4.3%
4.1%
4.1%
4.1%
4.1%
4.1%
4.1%
4.1%
4.1%
4.1%
4.1%
4.1%
4.1%
4.1%
4.1%
4.1%
3.8%
3.8%
3.6%
3.5%
3.5%
3.5%
3.5%
3.5%
3.5%
3.1%
2.8%
2.9%
2.9%
2.9%
2.9%
2.9%
2.9%
2.9%
2.2%

Table 7 Performance of All Policies, Premium Bonds

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.
24.
25.
26.
27.
28.
29.
30.
31.
32.
33.
34.
35.
36.
37.
38.

Premium Bonds
Policy
Total 1/65-1/80 1/80-12/08
Perfect Timing
15.5%
8.6%
19.1%
Alternative Policy
7.3%
3.7%
9.3%
5% Savings, 100% Escrow Eff
5.6%
4.7%
6.1%
6% Savings
5.5%
4.7%
5.9%
90% Refunding Efficiency
5.5%
4.2%
6.2%
25bps Savings, 20% NegArb/Savings
5.3%
4.7%
5.6%
25bps Savings, 50% NegArb/Savings
5.3%
4.7%
5.6%
25bps Savings, 75% NegArb/Savings
5.3%
4.7%
5.6%
25bps Savings, 90% NegArb/Savings
5.3%
4.7%
5.6%
3% Savings, 20% NegArb/Savings
5.3%
4.7%
5.6%
3% Savings, 50% NegArb/Savings
5.3%
4.7%
5.6%
3% Savings, 75% NegArb/Savings
5.3%
4.7%
5.6%
3% Savings, 90% NegArb/Savings
5.3%
4.7%
5.6%
95% Refunding Efficiency
5.3%
3.7%
6.1%
85% Refunding Efficiency
5.2%
4.4%
5.6%
5% Savings, 95% Escrow Eff
5.2%
4.7%
5.4%
5% Savings
5.1%
4.7%
5.3%
5% Savings, 50% Escrow Eff
5.1%
4.7%
5.3%
5% Savings, 60% Escrow Eff
5.1%
4.7%
5.3%
5% Savings, 70% Escrow Eff
5.1%
4.7%
5.3%
5% Savings, 80% Escrow Eff
5.1%
4.7%
5.3%
5% Savings, 90% Escrow Eff
5.1%
4.7%
5.3%
3% Savings, 100% Escrow Eff
5.0%
4.7%
5.2%
4% Savings
4.8%
4.7%
4.8%
25bps Savings, 20% Delta+
4.8%
4.7%
4.8%
25bps Savings, 50% Delta+
4.8%
4.7%
4.8%
3% Savings, 20% Delta+
4.8%
4.7%
4.8%
3% Savings, 50% Delta+
4.8%
4.7%
4.8%
3% Savings, 50% Delta
4.7%
4.7%
4.7%
3% Savings, 95% Escrow Eff
4.5%
4.7%
4.5%
NYS / MTA Table
4.5%
4.9%
4.4%
3% Savings, 90% Escrow Eff
4.5%
4.7%
4.4%
3% Savings
4.5%
4.7%
4.4%
3% Savings, 50% Escrow Eff
4.5%
4.7%
4.4%
3% Savings, 60% Escrow Eff
4.5%
4.7%
4.4%
3% Savings, 70% Escrow Eff
4.5%
4.7%
4.4%
3% Savings, 80% Escrow Eff
4.5%
4.7%
4.4%
25bps Savings, 50% Delta
4.4%
4.6%
4.3%
100% Refunding Efficiency
4.1%
3.1%
4.7%

15

6. Conclusion and Looking Ahead

Our study of the performance of a variety of refunding policies, several of which are currently
used in practice, and some of which are indeed considered best practices, shows that there is great room
for improvement. The performance of the Alternative Policy clearly indicates that it is deserving of
consideration by issuers as a replacement for existing policies as it greatly outperforms current best
practices. Performance, however, is not the only attractive property of the Alternative Policy. We believe
that a good refunding policy possesses four additional features:
1. The determination to exercise is done with simple calculations
2. The policy is easily understood
3. The policy is effective through rate cycles
4. The policy can be uniformly applied across bonds with a variety of different characteristics
The Alternative Policy indeed displays all four.9 The question that remains, however, is how much better
could a realizable policy with the above features perform? Figure 7 along with Table 6 and Table 7,
while highlighting the exceptional performance of the Alternative Policy relative to the other polices
tested, shows that the Alternative Policy falls short of the perfect timing, or optimal, policy.
How then do we approach the pursuit of further improvements? As seen in Figure 7, it is
sometimes the case that where the Alternative Policy does not perform well, other polices, even the
venerable 3% Savings Percentage policy, perform at least adequately. Are there then indicators for
switching from one policy to another, perhaps based on an issuers view of future interest rates? Would
such a policy lead to additional complexity that breaks from the four features above of a good policy?
These are questions that may be addressed in future research.

Recall that additional details on the implementation of the Alternative Policy can be found in (Orr and de la Nuez
2014).

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APPENDIX A Refunding Criteria Descriptions

Table 7 Description of Criteria for Refunding Policies Tested
Criterion
Savings Percentage
OCI

OCI+

Escrow Efficiency

Negative Arbitrage / Savings

Refunding Efficiency

NYS/MTA

Description
Exercise when the present value savings as a percentage of refunded par
is greater than a given threshold such as 3%.
Consider a move downward in the refunding rate by a certain fixed
number of basis points (e.g. 10bps). If savings are not improved by more
than a given threshold (e.g. 10%), exercise at the current rate. Typically
OCI is used in conjunction with another criterion.
OCI+ is the same as OCI but with an accompanying move in the escrow
rates applied in addition to the move in refunding bond yield before
considering the change in savings.
Exercise when the escrow efficiency is greater than a given threshold
such as 90%. The escrow efficiency is the ratio of the escrow cost
yielding the refunding arbitrage yield to the realized escrow cost.
Exercise when the negative arbitrage divided by the present value savings
is less than a given threshold such as 20%. The negative arbitrage is the
difference between the realized escrow cost and the perfect escrow cost
where the escrow earns the refunding arbitrage yield.
Exercise when the refunding efficiency is greater than a threshold such as
85%. Refunding efficiency is a ratio of present value savings to option
value. Some calculate the option value using a no-arbitrage option pricing
model such as Black-Karasinski or Black-Derman-Toy.
The NYS/MTA criterion is a table-based criterion, whereby the
exercise decision is determined by a simple Savings Percentage
threshold, but the threshold depends on characteristics of the refunded
bond. Those characteristics are used to create a table of thresholds. The
MTA criterion uses years remaining to maturity and years remaining to
call:

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