The cost of including a call provision in municipal debt contracts

Municipal bond market studies testing for the effect of a call provision on new‐issue borrowing cost fail to examine if the cost of the call provision is sensitive to expected changes in interest rates. This may explain why some studies find that the presence of a call provision increases municipal borrowing costs while others find no effect. Another possible reason for the contradictory findings may be a failure to correct for a self‐selection bias that results when some issuers choose to include a call provision and others do not. To correct for the potential self‐selection problem, a two‐stage probit switching regression technique is used here to estimate the cost of a call provision to municipal issuers. Results indicate municipal issuers pay a premium for the call privilege at the time of issue and that the size of the premium is sensitive to expected changes in interest rates.