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The Cost of Inefficient Coupons on Municipal Bonds

Published online by Cambridge University Press:  19 October 2009

Michael H. Hopewell  and
George G. Kaufman
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Extract

Ceteris paribus, investors prefer to purchase municipal bonds selling close to their par value. That is, investors are willing to purchase at the lowest yield a municipal bond alike in all respects to other municipal bonds, but with a coupon that permits it to be sold at or near its par value. Conversely, investors are willing to purchase municipal bonds with coupons that cause them to be sold at prices either greatly above or greatly below par only at penalty or premium yields relative to similar par bonds.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 9 , Issue 2 , March 1974 , pp. 155 - 164
Copyright
Copyright © School of Business Administration, University of Washington 1974

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References

1 In practice, there are a number of factors that may make a discount bond attractive to particular investors and that reduce the penalty yield to less than the capital gains equivalent. Harris, Alfred T., “Deep Discount Tax-Exempt Bonds: Who Buys Them—Why,” The Bond Buyer, November 30, 1964, pp. 40, 42–43Google Scholar; Renshaw, Edward and Forbes, Ronald, “The Case for Zero Coupon Bonds,” The Daily Bond Buyer, May 30, 1972, pp. 43–44, 46Google Scholar. The bonds may also be subject to state, city, or county income tax in addition to federal tax.

2 This project is financed in large part by a grant from the Research Applied to National Needs program of the National Science Foundation (GI-39486).

3 Hopewell, Michael and Kaufman, George G., “Costs to Municipalities of Selling Bonds by NIC,”(paper presented to Western Economic Association,August 16, 1973)Google Scholar; Moak, Lennox, Administration of Local Government Debt (Chicago: Municipal Finance Officers Association)Google Scholar; Porter, Richard J., “Underwriters' Price Policy for Municipal Serial Bond Offerings,” (Ph.D. dissertation. University of North Carolina, 1965)Google Scholar; Robinson, Roland I., Postwar Market for State and Local Securities (Princeton, N. J.: National Bureau of Economic Research, 1960)CrossRefGoogle Scholar; West, Richard R., “The ‘Net Interest Cost’ Method of Issuing Tax Exempt Bonds: la It Rational?,” Public Finance (Fall 1968).Google Scholar

4 “ Until recently only two major municipal issuers in the United States, the Los Angeles Departments of Water and Power and of Airports, awarded their bonds on TIC.

5 Alternatively, the spread could be added on the par value of the individual bonds so that the aggregate par value of the bonds less the spread is equal to the dollar amount actually sold, or the spread could be incorporated in the coupons of some or all of the maturities.

6 Because the matrix of coefficients for the cash flow constraints is a square upper triangular matrix, the solution can also be obtained quite easily without the aid of a computer program.

7 This method has been suggested by Lennox Moak, Director of Finance of the City of Philadelphia, and Ehlers and Associates, Inc., of Minneapolis in private communication with the authors.

8 This objective function minimizes the present value of the cash flows. Alternatively, the aggregate interest payments may be minimized:

The constraints remain the same.

9 Hopewell, Michael H., Kaufman, George G., and West, Richard R., “‘Lowest’ Bond Bid Costs Minnesota Extra One Million Dollars” (unpublished paper, University of Oregon, October 1972).Google Scholar