The Municipal Build America Bond Risk Premium

Terry Benzschawel

This article was first published as a chapter in Credit Modelling (2nd edition), by Risk Books.

Chapters 5 and 6 described methods for calculating the risk premiums and embedded leverage in corporate bond and CDS markets. In this chapter, similar methods will be used to provide insight into the compensation for credit risk and embedded leverage in the municipal Build America Bond (BAB) market. Motivation for this analysis is both to measure the credit risk premium in the municipal bonds as well as to determine if that information can be used to derive relative value trading strategies in BABs. BABs were chosen for this analysis because, unlike most other municipal bonds, they are taxable, thereby enabling one to analyse their yields using the same techniques that are typically applied to corporate bonds. Nevertheless, the approach is less straightforward than for cash and CDS markets in that there are no well-established methods for assigning probabilities of default to municipal bonds, reliably estimating their relative values, or any known attempts to measure municipal bond risk premiums.

The chapter will begin with a description of municipal bonds, BABs and the BAB market