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winthroptsmith
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Erratic Bond Pricing?

August 15th, 2014, 8:35 pm

Here is an unusual puzzle that I recently posted on my blog:At a recent conference about the U.S. municipal bond market, I made a brief presentation in response to a paper(1) that described a new approach to deriving yield curves from municipal bond trade data. The authors have applied neural network techniques to the problem of finding underlying term structures for different segments of the municipal market.I wanted to encourage researchers into the muni market to always be mindful of its unique quirks and complexity. To make my point, I shared this chart(2) with the audience: I explained that the chart represented the average yield spreads(3) for recent trades of certain bonds. The bonds have the same issuer and the same remaining maturity of approximately twelve years.The bonds traded on only a few days last month. Notice the extreme swings in the reported average yield spreads. One day the average yield is 26 basis points (0.26%) over a relevant index, and a few days later it almost 60 basis points below the index. The average yield continued to bounce around violently for the rest of July.I asked the audience what might explain this apparently erratic pricing. What would you say?(1)Integrating Big Data, Neuroeconomics, and Learning Networks to Model the US Municipal Bond Term Structure by Gordon Dash, Nina Kajiji and Domenic Vonella.(2)The chart I presented at the conference included some details that are omitted here.(3)On all days when trades occurred, these are the simple averages, for all trades, of the spread of yield-to-worst to a 12-year municipal bond index. Yield-to-worst is the lowest of the yields, corresponding to the traded price, for the various scenarios in which the bond either runs to maturity or is called on any of its call dates.
 
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bearish
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Erratic Bond Pricing?

August 16th, 2014, 4:22 pm

I could think of a couple of different factors driving this pattern, including coupon effects or a mix of retail vs institutional trades done at very different levels, but my best guess is that you have one bond that is pre-refunded and trades close to a Treasury level and another that carries some meaningful amount of credit risk.
 
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winthroptsmith
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Erratic Bond Pricing?

August 16th, 2014, 4:42 pm

You're getting warm in some ways. You might be the first to suspect that there are two bonds here.The coupons are close and the credit risk is the same. The trade types are not relevant, but thinking about refundings is useful.
 
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bluetrin
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Erratic Bond Pricing?

January 9th, 2015, 9:21 am

Since you mentioned that they have the same credit risk, I guess it could not be that one is double-barreled.I am not familiar with the muni market, but could one have implicit optionality such as callability ?
Last edited by bluetrin on January 8th, 2015, 11:00 pm, edited 1 time in total.
 
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winthroptsmith
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Erratic Bond Pricing?

January 11th, 2015, 3:49 am

Yes, the key is callability. There are two bonds. One has a shorter call and can be "advance-refunded" (the exercise of the call feature can be arranged in advance with an escrow), and the other has a long call and cannot be advance refunded. On the three days with a high spread, only the long calls traded. The two days with a low spread correspond to the shorter call, and the day with an intermediate spread included trades for both bonds. The point of the puzzle is to highlight a shortcoming of the muni market convention of benchmarking by maturity but not by the call feature. In practice, long maturity bonds with short, in the money calls may seem to price off the shorter part of the yield curve. This can lead to wild spreads to the supposedly correct benchmark.
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