Municipal bond price transparency: what it means for issuers.
The municipal bond market is undergoing dramatic changes today. A wave of information about bond prices and the financial condition of issuers is roiling the traditionally calm waters of tax-exempt finance and investing. Much of the change is generated by industry-supported regulations on disclosure in the secondary market. As market participants scramble to get ahead of the wave, many observers foresee a stronger secondary market for tax-exempt bonds, increased liquidity, and potentially lower financing costs for issuers.
Although much of the recent attention among market professionals has focused on the Securities and Exchange Commission's (SEC) new rule 15c2-12 enhancing secondary market disclosure, parallel developments related to "price transparency" may have an equally profound impact. Price transparency includes a number of independent initiatives, one led by the Municipal Securities Rulemaking Board (MSRB), the industry self-regulatory organization, while two others are sponsored by municipal securities dealers through the Public Securities Association (PSA).
Individual Investor Market
What makes price transparency so important? The answer is apparent only if one understands the distinctive nature of the municipal bond market. It begins with individual investors, who make up the largest portion of municipal bond holders. Until the mid-1980s, commercial banks represented the lion's share of bond purchasers, but changes in federal tax law removed incentives for banks to invest in municipals. As a result, bank holdings have dropped substantially, and individuals now constitute the largest group of bond investors, holding almost 70 percent of municipal debt directly or through bond funds and unit investment trusts. The Federal Reserve calculates that direct holdings of tax-exempt bonds by "U.S. households" (versus funds, banks, insurance companies, or other entities) account for $370.3 billion of the $1.16 trillion market.
In the past, these individual investors have had little direct access to information about bond market values. When the time came to buy or sell a municipal bond, they obtained most of their information, including daily price quotes and yields, from one or more brokers. Investors who sought to follow the changes in prices and yields of a single bond or a portfolio of bonds, just as they might follow their stock portfolios, usually could not do so without going to a broker. Why? Unlike exchange-traded markets, which report a single daily price for each security, the municipal bond market is an over-the-counter (OTC) exchange with market makers competing with each other to obtain the best price for themselves and for their customers. Different brokers may quote a slightly different price for the same bond, depending partly on a complex set of valuation factors to be discussed below.
Another distinctive feature of the municipal bond market: there are no newspaper listings of individual prices. That is no great surprise when one considers that a complete table of all 1.5 million outstanding municipal bonds would fill approximately 90 full pages in a newspaper. The absence of municipal market data in statistical listings carries over into the editorial coverage: despite the empirical evidence that many newspaper readers probably own municipals, most personal finance and investment stories tend to ignore tax-exempt investing. In a sampling of the 20 largest metropolitan newspapers conducted earlier this year, only seven published municipal yield tables while only one, The Columbus Dispatch, featured a weekly column devoted to the municipal market.
The municipal market has another characteristic that has made it difficult for investors to obtain price information: comparatively low trading volume. Most investors buy municipal bonds and hold them until maturity. As a result, estimated daily trading volume is $3 billion, versus $10 billion for equities and $10 billion to $15 billion for corporate bonds. In a market that has relatively few transactions, as well as a vast number of securities that trade only rarely, the most definitive indication of current value--a current or recent transaction--simply may not exist.
Pricing Information Sources. Traditionally, the retail brokers who quote prices and yields have helped investors resolve this dilemma by sorting through the myriad of professionally available information sources to obtain the indications of market value. Among the most widely utilized sources is the Blue List, a daily list of municipal bond offerings with descriptions and prices available daily in print or electronically. Other sources are outside municipal bond pricing services, the bid and offer lists provided by brokers' brokers, various indices of bond prices for selected maturities, and yield curves and generic scales for various segments of the market.
Using these sources, each bond dealer offers a bond at a price that takes into consideration the prevailing level of interest rates, the bond's maturity, the size of the order, the creditworthiness of the issuer, supply and demand for the bond, investor awareness of the issuer and whether it comes to market frequently, and the level of service being provided to the customer. Also included is the broker-dealer's own evaluation of market supply and demand.
Regulatory and Industry Action. This sometimes complex evaluation process by brokers has not always been clear to individual investors, especially those who are familiar with an exchange-traded market. Many bond dealers are aware that some investors, who may prefer a single-price environment, are frustrated and confused by the municipal market. The frustration may be particularly acute for investors who initially purchased municipals with the intent to hold them to maturity but unexpectedly may find they need to liquidate.
Over the years, discussions among brokers focused on price transparency as a potential solution to these problems. It was generally agreed that if investors were better informed, overall confidence in the market would be enhanced. Progress was stymied, however, by the lack of a central reporting system for transaction prices. In the summer of 1994, the discussions intensified in response to an SEC proposal that dealers disclose their mark-up on certain types of municipal transactions. The idea was to stimulate comparison shopping for the best price and thereby improve retail investors' understanding of the value of the municipal bonds they own or seek to buy. Dealers readily accepted the objective but argued that investors were better off comparison shopping to seek the best price rather than the most favorable mark-up, which might not result in the best price.
MSRB Forms the Foundation. Convinced that price transparency was a better way to achieve the SEC's objective and improve investor confidence in the market, dealers turned to a plan emerging from the MSRB. The MSRB proposal addressed the central problem: lack of public transaction price reporting. In a formal price-transparency pledge accepted by the SEC, the industry fully incorporated the MSRB's program into its own price-transparency plan.
Since its launch in January 1995, the MSRB program has significantly increased the amount of actual transaction data available to the marketplace. The first phase of the program captures interdealer trades that are collected from the National Securities Clearing Corporation (NSCC). The daily MSRB reports include prices of bonds that trade four or more times that day. The data include the high, low, and average transaction price of the bond, as well as the name of the issuer, the date of issuance, and its maturity.
In its second and third phases, tentatively scheduled to begin in January 1998, the MSRB also will report transactions between dealers and institutional investors, as well as retail-to-dealer transactions. Phase four will report transactions on a same-day basis rather than the current one-day delay.
Municipal Industry Products
Industry professionals believe the MSRB data will trigger improvements in price analysis throughout the industry. For example, the pricing services on which brokers and mutual funds rely now will have more precise data on which to base their evaluations. As a result, portfolio valuations and periodic investor statements also are expected to improve.
Throughout the second half of 1994 and most of the early months of 1995, industry leaders fashioned their own contribution to price transparency. While the MSRB plan focused on data collection, the industry effort recognized the need to distribute the information in a handy, easy-to-access form to retail customers. Their answer: two pricing sources that bridged the gap between the professional community and the individual investor.
The first, the PSA/Bloomberg AAA Insured Revenue Yields Table, presented in Exhibit 1, is designed to show investors how municipal yields change on a daily basis. A benchmark for the municipal market at large, the table shows yields of insured triple A-rated revenue bonds in maturities of two, five, seven, 10, 15, 20, and 30 years with comparisons for the federal taxable equivalent yield at a 31 percent tax rate. Bloomberg computes the table from quotes reported by brokers, analysts, and portfolio managers, as well as from new offerings. Versions of the table appear daily in USA Today and occasionally in The Los Angeles Times. In late October, The Philadelphia Inquirer started running the table on weekends with information from local issuers, as shown in Exhibit 2. In addition, The Rocky Mountain News reports it may run the table along with MSRB transaction prices from Colorado bonds.
Exhibit 1 PSA/BLOOMBERG NATIONAL MUNICIPAL BOND YIELDS
Triple-A Insured Revenue Bonds Recent Rates Below. For the latest, call (609) 279-3875
Jan. 25, 1995 Fed. Taxable Week Ago 6-Mos. Ago Maturities Yield Equivalent Yield Yield Yield @ 31% Two Year 5.15% 7.46% 4.92% 4.28% Five Year 5.45% 7.90% 5.32% 4.91% Seven Year 5.65% 8.19% 5.56% 5.19% Ten Year 5.95% 8.62% 5.87% 5.50% Fifteen Year 6.35% 9.20% 6.29% 5.93% Twenty Year 6.51% 9.43% 6.49% 6.13% Thirty Year 6.58% 9.54% 6.54% 6.21%
The above table lists yields for national triple-A tax-exempt insured revenue bonds with ten year call protection. Yields on specific bonds may vary based on supply and demand and whether bond interest is exempt from state income taxation. In addition, for bonds which have coupons that are significantly different from any of the yields in the table, bondholders should expect yields that differ from those stated above. The taxable equivalent yields in the table are calculated using the Federal income tax rate of 31%. Taxable equivalent yields would be higher for bondholders subject to a marginal tax rate of more than 31%. The above table is provided by the Public Securities Association and Bloomberg L.P. to be used solely as a benchmark for the particular category of tax-exempt municipal bonds described herein.
[Exhibit 2 ILLUSTRATION OMITTED]
The second industry initiative provides pricing information on specific bonds and uses the popular method of a toll-free telephone number (1-800-BOND-INFO). This service, the Standard & Poor's/PSA Municipal Bond Service, provides estimates as we'll as transaction prices on more than 700,000 bonds. The cost is $9.95 for 25 quotes. As of October 27, 1995, the service has provided more than 2,500 bond prices--actual transactions and estimated prices--to 984 callers. In a survey of callers, Standard & Poor's found that investors have specific goals in mind for their municipal bond investments. Current income was mentioned by 48 percent of respondents, while 26 percent cited retirement planning, and another 4 percent said they invest in municipals for college funding. The remaining 7 percent had a variety of other reasons. In addition, more than half hold their bonds to maturity, while 45 percent sell before maturity.
Both industry initiatives--the telephone service and the yield table--bring price data, particularly the MSRB transaction information, another step closer to the individual investor. When used individually or together, they offer an opportunity for investors to obtain a reasonably accurate indication of the resale value of bonds and bond portfolios. For those who may be confused when talking with a broker or "shopping around for the best price," the services constitute a reference point against which to compare brokers' quotes for the same or similar bonds.
Good News for Issuers
The development of price transparency is good news not only for investors but for the issuers of tax-exempt municipal bonds as well. Now finance officers, treasurers, and elected and appointed officials can know more than ever about the trading patterns of their bonds in the secondary market. Information indicating current market values can help issuers evaluate and anticipate potential investor interest and pricing levels for future offerings. Knowing the market can represent a significant competitive advantage.
Price information can be especially handy for those issuers who actively promote their bond offerings in written materials and presentations to investor groups and sales professionals. A consistent record of transaction prices can be a selling point. It indicates a degree of liquidity that may attract a growing number of investors, particularly those who do not intend to hold the bond to maturity. Those investors may be willing to pay more for bonds from an issuer that "trades" more actively in the market. Assuming the issuer can attract a large enough pool of such investors, financing costs could be reduced, sometimes significantly. This is a classic investor-relations strategy that corporations pursue, and more public bond issuers are following. As any corporate investor-relations professional will attest, the more an issuer knows about the buyer's market for an entity's outstanding securities, the more successfully new capital can be raised in the future.
Issuers who want to take advantage of price information use the same sources that investors access. For example, interdealer trading in a municipality's bond is available in three accessible venues: by checking MSRB listings in The Bond Buyer or on Bloomberg Business News Service or by calling 1-800-BOND-INFO. Daily price changes can be compared against movements in the general market reflected in the PSA/Bloomberg AAA Insured Yield Table. In most cases, prices generally should move in the same direction.
Issuers also may want to check transaction prices in the days and weeks following a new offering. In fairly quiet markets, prices remain relatively stable, while sudden changes in trading activity and prices reflect overall market volatility. Issuers may use this as one way to confirm that an underwriter correctly anticipated market demand and that the municipality obtained financing at the lowest cost at that time.
Price Transparency Has Limits
Some issuers also may want to leverage the advantages of price transparency in connection with their financial reporting obligations under the SEC's new secondary market disclosure rules. It may be reasonable to assume that material events reported by an issuer should generate a market response, such as unusual price changes, increased transactions, or both. Thus far, however, the direct cause and effect between a material event--such as a ratings downgrade--and changes in trading activity or prices is nearly impossible to confirm.
In the interdealer market where blocks of $1 million to $10 million are traded in a single transaction, trades do not always occur immediately after a dealer expresses interest. Buy or sell orders posted by brokers' brokers, for example, may wait for several days or even weeks before a broker finds the other side of the trade, especially if the bond comes from a relatively small or unknown issuer. A "bid wanted" put out by a dealer may come and go and never draw a single response. This measured pace of trading in today's interdealer market may not change dramatically when the MSRB begins collecting data on retail transactions.(1) Most professionals expect to see more of the same unless, and until, individual investors begin to look for value and capital gains--perhaps stimulated by changes in the tax code. Currently, however, price gains on tax-exempt municipal bonds are taxable.
What is ahead for the municipal market and issuers looking for greater advantages from price transparency? More transaction information from the MSRB will lead to improvements everywhere. Today's collection of interdealer trades probably reflects only one-third to two-thirds of the overall activity. With the addition of retail transactions and institutional (i.e., mutual funds) trades, a more complete picture of market activity can be expected. Others have suggested improvements to the MSRB reports, such as the addition of yield to maturity or yield to first call. As for the yield table, Bloomberg is already developing customized versions for newspapers that would carry information on bonds from issuers within the paper's coverage region. While it currently serves 150 papers, Bloomberg hopes the yield table will be published in each of the top 20 major markets in the future. Meanwhile, more features may be added to the 1-800-BOND-INFO service that will better serve its emerging audience, many of whom have shown an unexpected degree of sophistication. The majority of callers, for example, know their bond's CUSIP number, the nine-digit identification number assigned to each security. With this in hand, the caller might prefer to enter the CUSIP on the telephone touch-tone keypad rather than speak with operators, who currently must handle each call individually.
Computer technology may offer an even more exciting potential than the newspaper media or the telephone system. Personal computers could make the market more price transparent than even the most optimistic forecasters thought possible. Indeed, the introduction of computers into the home blurs the distinction between individual investor and professional. Depending on mass-market demand and the efficiencies of data processing, huge advances may only be a matter of time. As millions of Americans launch themselves into the web of electronic networks armed with vast reserves of electronic memory and lightning-fast data processing capability, checking prices on 1.5 million bonds could be a "point and click" away.
In fact, on-line products are already appearing. Among the first is BONDS ONLINE, a system from Twenty-First Century Municipals, Inc., that provides access to transaction prices and price estimates through Microsoft's Windows 95. The system is designed for individuals as well as small institutional investors, and it taps many of the well-established professional sources.
Primary Market Benefits. In addition to connecting more investors to the secondary market, electronic systems could be a boon to the primary market as well. For example, a Chicago municipal bond firm recently created a mini database on its Internet home page with investor information about a new offering it was underwriting. The database, the first of its kind, featured access to a summary of the bond issue, information about the issuer, and an e-mail address to send requests for a copy of the official statement. In addition, a more wide ranging directory of new bond offerings is available through BONDS ONLINE. Users may access information on all 50 states by clicking on selected areas of a U.S. map displayed on the screen.
All the evidence indicates that the future of price transparency is very bright indeed. Price information services have a multiplier effect, as different presentations from various reporting services trigger demand from a broader audience of current and potential investors. Joe Mysak, editor of Grant's Municipal Bond Observer predicts that the size of the municipal market will double by the year 2000, in part because "price information" will lead ineluctably "to more trading and higher volume and to more liquidity." That is a bold prediction but quite possible if investors change their current habits and begin to buy and sell municipal bonds more frequently, investing for value as well as income. Nothing could be better for municipalities looking for the most efficient methods of financing sorely needed new roads, bridges, schools, sewers, and other infrastructure projects.
(1) For information on settlements in the municipal bond market, see "What T+3 Settlement Means for Municipal Bond Market Participants" in the June 1995 issue of Government Finance Review.
Heather L. Ruth is president of the Public Securities Association (PSA). PSA is the bond market trade association, representing securities firms and banks that underwrite, trade, and sell debt securities both domestically and internationally. PSA's approximately 300 member firms collectively account for about 95 percent of the nation's municipal securities underwriting and trading activity and include all 37 primary dealers in government securities, as recognized by the Federal Reserve.
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|Author:||Ruth, Heather L.|
|Publication:||Government Finance Review|
|Date:||Dec 1, 1995|
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