Modeling Municipal Yields with (and without) Bond Insurance

We develop an intensity-based model of municipal yields with (and without) bond insurance, making simultaneous use of the credit default swap (CDS) premiums of the insurers and both insured and uninsured municipal bond transactions. We estimate the model using 61 issuers with relatively continuous municipal bond trading from July 2007 to June 2008, and decompose the bond yield based on the estimated parameters. The model fits municipal yields as well as Duffee (1999)'s for corporate yields, and the decomposition reveals that the liquidity component plays a dominant role in the municipal yield spread, and is somewhat larger for insured bonds than uninsured bonds. Towards the end of the sample period, our model reproduces the "yield inversion" phenomenon documented by Bergstresser et al. (2010).