The Municipal Bond Secondary Market
Like any other security, municipal bonds often are disposed of before their maturity. Heirs sell, institutions acquire different tax-exempt needs, commercial banks see deposits rise or fall cyclically, syndicates break up and divide the unsold bonds among their members, and so on. Whatever the reasons, bonds return to the market to be offered to the investing public for a second time--hence the term "secondary market." The volume of transactions in the secondary market, in terms of par value of bonds traded, far exceeds that of the "new issue" market. Daily volume of secondary offerings, as shown in The Blue List:, together with estimated unadvertised blocks, would suggest an annual secondary to primary market ratio of 20 to 1.
There are two types of trading markets: (1) over-the-counter or negotiated trade markets and (2) auction markets. Municipal bonds are most often traded in over-the-counter markets, in which any individual may go for his own account or may arrange for a recognized dealer to act as an agent. Over-the-counter trading market encompasses generally all types of securities, including United States government, foreign bonds, corporates, railroad stocks, common and preferred stocks, script, rights, warrants, and municipal bonds. Auction markets generally are reserved for listed securities on the national exchanges, where the price of the security is set by the highest bid or the lowest offer.
The over-the-counter market consists of thousands of broker/dealers located throughout the country and transacting business by telephone. Broker/dealers can buy or sell securities either as customers' brokers (agents) or as dealers (principals). The broker receives a commission for executing the customer's orders; the cutomer benefits from any profits and assumes the responsibility for losses. When acting as principals, dealers buy and sell securities for their own inventories and not for their customers, and thereby assume the risk of ownership.
Unlike its corporate counterpart, the municipal bond secondary market is not a formal market--there are no public listings of sale offerings and no regular trading hours; nor does the brokering occur at a formal institution, such as the New York Stock Exchange. The municipal bond secondary market provides individual and institutional investors a mechanism through which to buy and sell municipal bond holdings prior to the bonds' maturity dates. Investors thus have an easy and quick way to manage investments and regulate cash flow to suit their specific needs.
Municipal bonds available for resale in the secondary market are listed in The Blue List by state with several major categories. The Blue List is a 100-page compilation of securities, along with their yields, offered for trade by dealers and is updated daily by Standard and Poor'sThe listings include the number of bonds offered, issuer, maturity date, coupon rate, price, and the dealer making the offering. Ratings are not included. The total dollar value of listings--referred to as the floating supply--provides an indication of the size and liquidity of the secondary municipal market.
The language used to describe a municipal bond available in the secondary market is fairly straightforward. For example, a "$25,000 State of Michigan, 3.50% of June 1, 2002, at a 4.75% yield" would be a municipal bond (or, more likely, bonds) with a face value of $25,000, issued by the State of Michigan, with a coupon rate of 3.50%, maturing on June 1, 2002, and trading at a price to yield 4.60% to maturity. Serial bonds are usually quoted on a yield-to-maturity basis (equivalent dollar price may be added as a convenience); term bonds are usually quoted only as a dollar price, or percentage of par value. For example, a quotation of 93 1/4 would mean a dollar price of $932.50 for a $1,000 par value bond (or $4,662.50 for a $5,000 bond).
The field of secondary trading is very competitive with spreads ranging from 1/4 of a point ($2.50 per bond) to two points ($20.00) in the case of obscure issues or odd lots. The average dealer's spread is $10.00 per $1,000 bond. There are three types of dealers.
(1) Securities dealers generally comprise a department within a large full-service securities firm that handles the accounts of both individual and institutional investors, as well as other dealers. Securities dealers in large firms may handle specific areas of the municipal bond market (e.g., short-term notes or public utility bonds) and are able to consolidate like orders and strategically buy (or sell) municipal bonds as the market allows.
(2) Dealer banks (trading departments within commercial banks) can trade in general obligation bonds in which they have no direct connection. To ensure there is no conflict of interest, dealer banks are prohibited from executing transactions for investors (individual or institutional trusts) whose accounts they supervise.
(3) Dealers' brokers trade only with other dealers or brokers and never with individual or institutional investors. Brokers are employed when dealers think they can achieve more efficient trading through a third party. Greatest strengths are brokers' access to segments of the market, continuous communication with dealers, and their guarantee of anonymity with respect to dealer identity and trading.
A broker's most common type of business are bid-wanted transactions, where securities dealers or dealer banks ask brokers to place on the market and take bids on bonds that the dealers want to sell to other dealers. Brokers also may handle bond-wanted transactions; that is, a broker is contracted to seek a particular bond or bond type desired by a dealer. Brokers may oversee the sale of municipal bonds for a set price to a particular segment of the market, as designated by the selling dealer. Equally important, once a syndicate has been dissolved, an underwriter may contract with a broker to sell the remaining bonds that were not sold by the syndicate.
Having access to up-to-date information is critical to a dealer's ability to trade effectively and efficiently. Dealers who subscribe to The Blue List also can have computer access to this information through the Blue List Ticker, which records up-to-the-minute additions and deletions of bond offerings. Municipal dealer offering sheets are weekly inventories of bond holdings that individual dealers are offering for sale and include the names of investors, the type of bond, and its yield or sale price. Dealers rely heavily on The Daily Bond Buyer which also provides a wire service, Munifacts, that lists daily offerings and bond yields. Wire services, such as the Kenny Wire and the C-Wire, offer over 600 bond dealers up-to-the- minute data on bond sales and purchases.
Two measures are especially watched as indicators of where the bond market is headed: (1) the placement ratio, which shows the proportion of all bonds (competitive and negotiated) over $1 million that were distributed during the week; (2) the 30-day visible-supply volume which shows all securities scheduled to be offered within a 30-day calendar period. The Bond Buyer publishes three yield indexes on a weekly basis: (1) 20-Bond Index reflects the yield on a general obligation bond with a 20-year maturity and is derived from bonds of 20 actual issuers with an average bond rating about halfway between Moody's top four rating categories; (2) 11-Bond Index is based on 11 of the 20 issuers in the 20-Bond Index which have an average rating of Aa from Moody's; and (3) Revenue Bond Index, reflects the yield on a 30-year revenue bond based on bonds from 25 issuers covering a variety of purposes. These indexes help dealers anticipate market trends, spot upcoming demand or supply of specific bonds, as well as know how much risk is involved in trading particular bonds at given yields.
Most municipal bond trades are settled on the third business day after the trade date (know as a "regular way trade"). Some municipal bonds are traded on a cash settlement basis on the same day on which the trade is made. Municipal bond settlements differ from corporate settlements in that the legal opinion must be part of the transaction. For bonds issued since the mid-1960s, the legal opinion is printed on the certificate; for older issues, the opinion is provided as a separate document.
Sellers of bonds are entitled to any interest that has accrued on the bonds up to the day before the settlement date. The following formula is used to calculate the amount of accrued interest:
Accrued Interest = Annual Interest x Days in holding period/360 days
For municipal bonds and some municipal notes, all whole months are assumed to have 30 days and the year is figured on the basis of 360 days. For example, a bond holder sells a bond for 97 1/2 (or $975) for settlement on July 27. The last interest payment on the bond was received on April 1 in the amount of $26.75; the next interest payment is due on October 1. The purchaser of the bond must pay $975 plus the accrued interest:
Accrued interest = (2 x 26.75) x (30 + 30 + 30 + 26)/360 = $53.50 x 116/360 = $17.24
Note that April, May, and June count for 30 days each and July for 26 days. The settlement on the bond sale (disregarding commissions and fees) would be $975 plus $17.24 = $992.24.
Uniform Practices for Municipal Bond Trading
The Municipal Securities Rulemaking Board (MSRB), an independent oversight agency established by the Securities Act of 1975, regulates the practices of municipal securities dealers, dealer banks, and brokerage firms. As part of its oversight responsibilities, the MSRB instituted rules G-12 and G-15 to codify uniform industry standards for good trading practices.
o Rule G-12 lays out practices regarding dealer transactions, including settlement dates (dates on which payment for bonds and the bonds themselves must be delivered), confirmation of transactions between dealers, reclamation or rejection of bonds already traded by dealers, as well as rules for finalizing an order that has been confirmed but not completed.
o Rule G-15 requires a verification of a customer's confirmation of transaction. In addition, the names and addresses of the customer and dealer, information on whether the transaction was a purchase or a sale, the type of bond traded, its call date and interest rate, the date and time of transaction and settlement, its yield to maturity and the final price must be supplied to the MSRB.
In October 1994, the Securities and Exchange Commission (SEC), which oversees the MSRB, released new rules mandating public disclosure in the secondary market. Thousands of cities and public agencies are now required to release an annual financial statement updating information provided in the issuer's official statement and to provide information on events that could have an impact on the value of outstanding bonds, such as the loss of a major employer or the closing of a military base. This information will be sent to the MSRB and national databanks, which dealers and investors can access. The SEC expects these disclosure rules to curtail price gouging by bond dealers, making them more responsible to investors for quoting accurate, up-to-the-minute prices as they resell bonds in the secondary market. When taken together, these rules strive to ensure a fair trading atmosphere for dealers and investors.
Tax Treatment of Discount
When a bond is purchased at a discount and subsequently sold or redeemed for a price in excess of the purchase price, only the interest is exempt from federal tax. The additional yield is taxable as a capital gain when realized. Thus, if a $1,000 bond with 3.25 percent interest coupons, maturing in 10 years was purchased for $958.60 to secure a 3.75 percent yield, the semiannual interest payments of $16.25 would be exempt from federal income tax.
When the bond is redeemed at the maturity date for $1,000, the appreciation of $41.40 would be capital gain for federal income tax purposes. When municipal bonds are issued at discount, however, the discount is considered to constitute compensation which the obligor has contracted to pay for the use of the money loaned and, therefore, is equivalent to interest for federal tax purposes. This does not apply where bonds, originally sold at par or at a premium, are subsequently reoffered at a discount.
Tax Exempt Municipal Investment Trusts and Bond Mutual Funds
First established in 1961, tax exempt municipal investment trusts have grown rapidly in investment popularity. These trusts are registered investment companies, the assets of which are invested in a diversified portfolio of tax-exempt bonds. Each fund is a closed-end trust created under the terms of a trust indenture by an investment banking firm that acts as "sponsor." The bonds to be owned by the trust are completely assembled, the trust is offered for sale to investors. Securities are deposited with a trustee bank (or trust company). In return, certificates, or units, are given to the sponsor, each certificate representing a fractional, undivided interest in the principal and net income of the trust. These certificates are then distributed to individual investors, either by the sponsors or by a group of investment firms forming an underwriting syndicate. The buyer of the shares in the trust knows what bonds he or she is buying. The portfolio of the trust is said to be supervised, not managed, and remains unchanged during the life of the trust. Over time, the trust decreases in size, as bonds mature, are called, or on rare occasions, are sold, until finally it becomes so small that it is discountinued, the bonds are sold, and the proceeds are distributed pro rate to the trust shareholders.
These funds have the objective of providing tax-free income con-sistent with preservation of capital and diversification of risk. All fund units have substantially been purchased by private investors, rather than institutional investors. Some funds include in the portfolio only bonds issued within a particular state, thereby gaining exemption from state income taxes as well as federal income taxes. [12]
In 1976, the Internal Revenue Service extended the tax-exempt status to municipal bond mutual funds. Many closed-end (funds which do not sell additional shares) and open-end funds have been created. The dividends from open-end funds are generally are used to buy additional shares. The funds are evaluated daily by a municipal bond evaluation firm, and like most mutual funds, shares may be redeemed ayt the net asset value.
Standard & Poor's has recently begun to rate bond mutual funds for market risk. As tax-exempt bond mutual funds have increasingly become an investment option for individuals (especially those on fixed incomes) in search of higher yields and security of principal, they have attracted millions of savers away from commercial banks. And because many of these investors may not understand how bond funds operate, officials in the investment industry are concerned about the safety of such investments.
Most mutual funds hold a mix of bonds of varying maturities and rates to smooth out the ups and downs. They also hold complicated derivatives, which are securities based on parts of a bond, such as principal payment or interest. These derivatives have complex rules and often move differently in price from the actual bond.
Bond prices move in the opposite direction from interest rates. As rates on new bonds increase, the price of older, lower-yielding bonds declines. As the prices of bonds in a mutual fund decline, the fund shareholders experience a loss of principal. Unlike individual bonds, which have a defined maturity period and rate of interest, bond funds have neither fixed rates nor a maturity date. The portfolio is always changing, and thus, the investor cannot be assured that any loss of principal may subsequently be recovered.
The new ratings to be undertaking by Standard & Poor's will attempt to account for changes in interest rates, the value of the dollar, and other factors that might adversely affect the prices of bonds and the mutual funds that buy them. The new rating system will be designed to alert investors to the possible volatility of a mutual bond fund. A limited number of bond funds are currently rated by Standard & Poor in terms of their credit risk--that is, are the bonds in the fund safe and will they produce the yields expected? The new system will add an alphabetical, lower-case rating to cover the market risk of the bond portfolio held by the fund.
Bond Ladder Investing
A ladder bond portfolio is designed to meet the needs of conservative investors who hold their securities to maturity. This strategy often is used by investors seeking ways to achieve the greater income yields of securities with longer maturities without the market risks of a portfolio comprised entirely of long-term bonds. By investing in several securities with staggered maturities, this strategy serves to safely increase yields, soften the impact of interest rate swings, reduce the exposure of principal, and steady equity holdings.
A bond ladder works by spreading investment dollars among bonds other fixed income instruments that mature at various times, often between one and thirty years from the time the ladder is built. An income portfolio is created in which each group of bonds represents a rung on the investment ladder. In a normal interest-rate environment, shorter maturities will yield less than longer maturities. As each individual bond (rung) matures, the principal becomes available for reinvestment at the then current interest rates. The value of a ladder is the ability to reinvest the principal from the maturing bond into a longer-term bond with a higher yield. As shorter term investments mature, the principal is invested at the ladder's long end. After a few years, the ladder portfolio may be largely comprised of longer term securities, typically purchased at higher yields.
Ladder portfolios are very flexible so that they can be structured to meet the unique needs of the investor. Ladders typically are built using a variety of fixed income securities, including tax-exempt municipal bonds (especially zero-coupon bonds which offer a discounted price and compounded interest), U.S. Treasury and government agency securities, corporate bonds, Ginnie Mae pass-through securities, collateralized mortgage obligations (CMOs), and longer term certificates of deposit.
With a ladder portfolio, principal payments come due every year or so to take advantage of improved interest rates. If interest rates fall, prior ladder holdings have locked up higher yields for longer periods. If interest rates remain the same, the longer-term yields should provide a return greater than if the investment were limited to short-term securities. If interest rates go up, the current market value of the fixed-income portfolio will fall; however, as each rung of the ladder matures, money is available to invest at the higher rates. The net result is a "smoothed" yield with less fluctuations in income because the ladder takes advantage of the effects of dollar cost averaging.
The predictability of income flow that this strategy can offer attracts local governments, foundations, endowments, and other tax-exempt income investors, as well as individual investors who may need large amounts of money available on certain future dates to pay for such expenses as a child's education or retirement. Bond ladders often are used by individuals who have received a lump sum, such as from an inheritance, an insurance settlement, the sale of a business, or the maturity of a large bond or CD. Ladder portfolios are appropriate for retirement assets, as well as investors who self-direct their retirement accounts, IRAs, Simplified Employee Pension (SEP) plans, Keogh plans, and those who manage retirement fund assets for others.
Endnotes
[1] Maynard Toll, CS First Boston, as quoted in The New York Times, March 19, 1996, p. C2.
[2] Robert B. Lamb, NYU Stern School of Business, op. cit., p. C2.
[3] For a more extensive discussion of the differences between competitive bidding and negotiated sales, see: Robert Zipf, How the Bond Market Works (New York: New York Institute of Finance, 1997), pp. 99-115.
[4] Robert Boyden Lamb, "The Primary Market: Underwriting Municipal Bonds," The Handbook of Municipal Bonds and Public Finance, eds. Robert Lamb, James Leighland and Stephen Rappaport (New York: New York Institute of Finance, 1993), p. 23.
[5] Donald Yacoe, "Crying Cronyism, Lawmaker Seeks Alabama Ban on Negotiated Deals," The Bond Buyer (Feb. 7, 1994), p. 1.
[6] John L. Mikesell, Fiscal Administration: Analysis and Applications for the Public Sector (California: Brooks/Cole Publishing Company, 1991),pp. 421-425
[7] Most new issues of municipal bonds go to the Depository Trust Company, a cooperative owned by its members and operated for their benefit.
[8] Christina I. Ray, The Bond Market: Trading and Risk Management (Homewood, IL: Business One Irwin, 1993), p. 72.
[9] Zvi Bodie, Alex Kane and Alan J. Marcus, Investments, 2nd ed. (Boston: Irwin, 1993)p. 457.
[10] Tom McLoughlin, "Choosing an Underwriter for a Negotiated Bond Sale", Government Finance Review (June, 1990), pp. 28-30.
[11] How the Bond Market Works (New York: New York Institute of Finance Corporation, 1988), pp. 135-146, 154- 156.
[12] For a further discussion of municipal investment trusts, see: Robert Zipf, How Municipal Bonds Work (New York: New York Institute of Finance Corporation, 1995), pp. 157-162.