Many investors are mystified by the difference between the way common stocks and bonds are traded.
Most are certainly aware of the two major stock exchanges, the New York Stock Exchange and the NASDAQ over-the-counter market. Orders for stocks are placed on a computer terminal and an execution usually happens within moments.
Placing an order for a bond, however, is a different process. One or more dealers have to be contacted by phone or by terminal to see what the available supply is for the type of bond you are looking for as well as several other factors such as the maturity, quality rating, and the yield to call and/or yield to maturity.
The Internet has improved the transparency of the process significantly in recent years, but the potential for abuse still exists for the unwary. The National Association of Securities Dealers (NASD) recently levied fines against eight major broker-dealers for overcharging clients on municipal bond transactions. While the amount of the fines is modest, the implications are significant.
Regulators are watching the municipal bond market more closely, and so they should. The Securities and Exchange Commission recently issued its Report on Transactions in Municipal Securities 2004. The result of this Report is a new rule requiring all municipal bond transactions to be reported within fifteen minutes, beginning in January. In an important way, this will contribute to pricing visibility in the municipal bond market. The additional information will enable investors to determine whether the bid and offer prices they receive are appropriate.
Until now, pricing data have been updated only as of the previous day's trades. In January, investors will be able to get almost real-time pricing, as well as historical trading information, on every municipal security. But compare this to an exchange-listed stock whose previous trade is reported instantly.
According to the SEC Report, there are approximately 1.1 million unique municipal bonds outstanding, worth about $2 trillion. This compares to the approximate 13,450 individual equity securities. The Report also notes that nearly two-thirds of the municipal issuers had $10 million or less in securities outstanding, and 70% of outstanding securities did not trade at all over the one year period studied by the Report. This huge volume of small issues and the lack of ongoing trading make the fair determination of a proper price for an individual security problematic. Imagine trying to sell a home in a neighborhood where a home of similar size and quality has not sold in the past year.
The concepts here are market depth and liquidity. The new rule should allow buyers and sellers of municipal bonds, individuals and professionals alike, to get the same information at the same time, allowing for a more fair and liquid market.
What about holders of municipal bond mutual funds? The same analysis applies here, too, since fund managers will have access to better pricing information. They will be able to make better decisions about the bonds they buy and sell, and they will have better information about the market in general.
What about bid-ask spreads? Logic dictates that bid-ask spreads should narrow. This will benefit investors on both sides of the trades. But how much investors will benefit and how long this takes to go into effect remain to be seen.
The SEC Report found that the mean spread for customer transactions was 1.84% of the dollar price of the bond. However, this masks some significant discrepancies. The Report also found that trades over $100,000 had a mean spread of only 0.36%, or 80% less than the overall average! Trades over $1 million had still narrower spreads.
Examples of unscrupulous brokers exploiting clients on both sides of a trade are too common. According to www.municipalbonds.com, wide and potentially illegal spreads continue to plague the municipal bond markets.
Having checked the site today for trades that occurred in the second quarter 2004, I can say with assurance that double-digit spreads are far too common. The new rules will serve to lessen the frequency and the total volume of such exploitative trading. They should also give pause to any broker-dealer contemplating such activity since there will be a complete pricing history record for an investor to check, should one feel he or she has been the victim of an abusive trade.
How is an individual investor able to determine whether he or she is getting a fair deal on the purchase or sale of a bond? Each day's municipal transactions are reported by midnight of the day of the trade and posted to the municipal bond section of the Bond Market Association's website, www.investinginbonds.com by the following day. The site also includes a wealth of user-friendly information about investing in bonds.
The current state of affairs should come as no surprise. With over one million municipal bonds, thousands of individual brokers, hundreds of broker/dealers, and no active electronic quotes, even professional investors have to go to great lengths to determine the proper price for an individual bond. Obviously, this is a Herculean task for an individual investor. Starting in January, the new rules should level the playing field and reduce the costs for all municipal bond market participants.
If you have any questions about bond pricing, we'll be happy to answer them for you.
Kenneth N. Green, C.P.A, B.S. (in Finance, University of Illinois), and M.B.A (in Finance, University of Michigan), is Senior Vice President and Director of Investments of Marc J. Lane & Company and Marc J. Lane Investment Management, Inc., the investment affiliates of The Law Offices of Marc J. Lane, A Professional Corporation.
The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright © 2007 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.