As regulators seek to overhaul the financial system in an attempt to make it more fair, watch them go after unsavory practices in the muni bond market.
Here’s the problem. Compensation for municipal bond issuance isn’t based on the realised bond price, (ie. the yield muni bonds achieve when issued), but rather based on the proceeds of the bonds (the principal).
At the same time, the institutional clients of bond underwriters have a substantial interest in getting muni bonds as cheap as possible.
Bloomberg: Underwriters sell the bonds in large blocks or amounts to so-called favoured institutional investors, such as mutual funds, who in turn sell them to other buyers, who sell them to individuals, the “retail” crowd. Traders, money managers, bond issuers and the former head of the Municipal Securities Rulemaking Board have all commented on how intermediate buyers profit by marking up bonds and reselling, or “flipping” them to individuals.
“There is an unhealthy relationship between the bond funds and the dealer community,” said Taylor, now a consultant based in Alexandria, Virginia. “I have long suspected that dealers throw money at the funds by selling them new-issue securities in blocks and then slowly buying them back at up-prices for sale to retail.”
Business Law Prof Blog: Flipping is common in the stock IPO market. It involves buying shares at the IPO price and then reselling or “flipping” them once trading has begun. Assuming the stock enjoys a first day pop, as many IPOs do, it’s a relatively low risk strategy for making a quick profit. An IPO pop, however, indicates that money was left on the table by the issuer, i.e., the issuer could have sold the stock at a higher IPO price. At the same time, a little money was left on the table by the underwriters of the deal as their compensation is tied to the gross proceeds of the deal (the number of shares to be sold is typically fixed, so a lower per share price results in lower gross proceeds).
Flipping of municipal bonds is slightly different: Let’s say a bond with a 5 per cent coupon due in 20 years is priced at 100, to yield 5 per cent. A big mutual fund manager gets a block of these bonds at 100. He sells them a week later at a price of 102, which has the effect of lowering the yield on those bonds to 4.84 per cent.
This indicates that essentially taxpayer money was left on the table by the municipality selling the bonds: A municipality that borrows $1 million at 5 per cent pays back $2 million: $1 million in principal, and $1 million in interest. A municipality that borrows the same amount at 4.84 per cent pays back $1 million in principal, and $968,000 in interest. The underwriters, however, did not leave any money on the table here because like with an IPO their compensation is tied to the gross proceeds of the deal which are not impacted by the interest rate.
Thus underwriter compensation isn’t tied to the pricing of the bond, and in fact lower pricing curries favour with institutional clients who can make small but frequent bond-flipping profits. Some might be able to defend this practice as providing liquidity, but there seems to be an oversight gap in the industry’s incentive structure worth addressing since the entity most concerned with proper muni bond pricing, the taxpayer, is being represented by government employees wh will get paid the same paid regardless of how well muni bonds price.
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