Yielding to Muni Market Transparency

August 10, 2017

A New Intraday Yield Curve
by Michael Palmieri

As reported by The Bond Buyer on July 21, the Municipal Securities Rulemaking Board (MSRB) announcedthat its Electronic Municipal Market Access (EMMA) now includes access to daily municipal market yield curves.

For those unfamiliar with EMMA, it is the official repository for information on virtually all municipal bonds, providing free access to official disclosures, trade data and other information about the municipal securities market. The intent is to blunt the information and price execution advantage that institutional investors have over retail investors in buying and selling munis.

The ultimate goal of EMMA is to bring full transparency to this popular, yet still unsophisticated and opaque $3.8 trillion market that affords tax-exempt opportunities across all investor spectrums. Some may question the usefulness to everyday investors of adding yield curve data. That’s another blog for another day. Towards the transparency goal and towards establishing a level playing field, it’s a positive step.

More noteworthy is the selection of the Associated Press (AP) – Municipal Bond Information Service (MBIS) U.S. Tax-Exempt Municipal Index as the source of the EMMA yield curve data, because it brings an entirely new level of transparency to the muni markets.

Trade Data vs Consensus

The AP/MBIS Municipal Bond Index is the only tax-exempt investment grade yield curve based on observable, intraday pre-trade and trade data. Unlike currently available muni benchmarks based on subjective survey-driven methodologies, the AP/MBIS Municipal Bond Index is produced from independently aggregated market data and constructed using a consistent, algorithmic rules-based system. The index is constructed from offered prices of approximately 4,000 bonds contributed intraday by 10 interdealer brokers. Updated hourly on the MBIS platform, it is dynamically rebalanced to include a large sample of bonds in the muni market with recent market observations. It tracks the offered side of the market, and includes smaller transaction sizes to reflect opportunities available to the individual investor. The full methodology is posted here on the EMMA website. The AP/MBIS Municipal Bond Index yield curve offers an objective, understandable benchmark currently unavailable in the municipal markets.

Why Non-Call Life Curves?

Bond analytics require an optionless non-call life (NCL) benchmark yield curve to accurately estimate, among other things, duration, forward rates, and relative values. In contrast to the standard benchmark Treasury or swap curves on the taxable side, standard muni curves are callable, and converting a callable curve into its optionless equivalent is computationally challenging.

Major vendors of benchmark muni curves do provide NCL curves, but these are often internally inconsistent with their callable curves. Occasionally, the benchmark curves are not arbitrage-free. This Bond Buyer commentary, Spread(ing) Confusion, shows how some undiscriminating traders and portfolio managers unwittingly use callable curves as if they were optionless, resulting in distorted duration and relative value measures.

AP and MBIS, partnering with Kalotay Analytics, address many of the shortcomings of the standard curves. The new curves are constructed using Kalotay’s CurviLinear™ software, driven by a tax-neutral option-adjusted spread (OAS) valuation engine. CurviLinear properly handles heterogeneous optionality among the constituent bonds, as well as the construction of an equivalent optionless par curve. The tax-neutral feature in CurviLinear handles the complexity of discount munis, whose prices incorporate their unfavorable tax treatment. Andy Kalotay’s paper Creating a Live Yield Curve in the Illiquid Muni Market (The Journal of Fixed Income, Summer 2017) and presentation at the 2017 Brookings Institution Municipal Finance Conference detail the CurviLinear methodology underlying the AP/MBIS Municipal Yield Curve.

Automated, Data-driven Intraday Muni Curves

Traders and portfolio managers now have access to meaningful, consistent muni curve updates throughout the day based on real trade data, delivered through a purely quantitative and fully automated process. This advance brings a higher degree of transparency to the municipal market and offers a platform for continued innovation and progress towards greater sophistication.