Review of Quantitative Finance and Accounting, 16, 5–32, 2001
2001 Kluwer Academic Publishers. Manufactured in The Netherlands.
The Optimal Redemption Schedule of Serial Municipal
Debt: A Dynamic Reconciliation of Revenues,
Reinvestment Rates and the Term Structure
BRYAN STANHOUSE AND DUANE STOCK
Division of Finance, 205A Adams Hall, Michael F. Price College of Business, University of Oklahoma,
Norman, OK, 73019, Fax (405)325-1957
Abstract. The purpose of our research is to develop an algorithm that optimally schedules municipal debt
redemptions. It is our hypothesis that segmentedinvestordemand,theexistingterm structure, the temporal behavior
of municipal project revenues and reinvestment opportunities for interim revenue surpluses are all factors which
should impact the optimal debt scheduling problem in a unique and economically meaningful way. For example,
investor preference for shorter maturities and an upward sloping term structure of interest rates should, ceteris
paribus, increase the proportion of debt scheduled to be repaid early in the redemption horizon. If investor demand
is limited to a relatively small geographic area, such limited demand should be reﬂected in higher yields. If
municipal project revenues increase over time then a larger proportion of the debt should be scheduled to be
redeemed later. Unfortunately, realistic acknowledgements of the nature of the municipal debt ﬁnancing problem
create an objective function and a set of constraints which are far too complex to yield simple reduced form
presentations of the optimal principal redemptions. Consequently, solutions to the optimal debt schedule and tests
of the conjectures articulated above were simulated.
Key words: municipal bonds, serial debt
JEL Classiﬁcation: G24
One major problem state and local governments face is the ﬁnancing of bond issues. In
1996, state and local governments sold 11,326 different issues for $183.3 billion, a 14%
increase in dollar valuefrom 1995 and the highest since 1993.
Furthermore, in the ﬁrst half
of l997, dollar volume surpassed that of the ﬁrst half of 1996 by over 3%.
aspects of municipal bonds are thus extremely important ﬁnancial issues for the United
The existing tenets of structuring municipal debt issues are that the structure of the bond
issue should consider 1) how the debt structure will match the life of the project, 2) how
to coordinate expected revenues with debt service requirements, and 3) how the issue will
comply with governmental debt policies.
The two most popular ways of structuring serial debt are to have level principal payments
over the life of the issue or, alternatively, to have level total debt service payments (principal
and interest) over the life of the debt. Such practices are oversimpliﬁed ways of complying
with the second tenet mentioned above. For example, municipal project revenues are rarely