A Surplus Optimization Approach to Managing Municipal Debt

Abstract

This article considers appropriate debt-funding strategies for state and municipal governments in the presence of a positive, tax-exempt term premium. In this context, the term premium measures the additional expected funding cost from issuing fixed-rate debt as opposed to issuing floating-rate debt. The correlation between a measure of income from rate-sensitive assets and the tax-exempt floating rate is the principal focus of the analysis. A single-period framework is used to identify the most important information required to design the optimal proportion of tax-exempt floating-rate debt for a municipal government. From this analysis, there are several compelling reasons for municipal entities to increase the quantity of floating-rate debt. This framework is used to assess the optimal state government debt maturity structure based on historical data.