How can there be a “fair market” in a market where at least 99% of trillions of dollars of fixed income securities offer no price discovery and where financial data cannot be quickly downloaded into a spreadsheet to analyze and compare to assess credit risk? Price” at a price?
That question has vexed investors, issuers and regulators in the $3.9 trillion municipal bond market for decades. The market’s lack of business information is only matched by the lack of digital financial information. This “double data void” exacerbates the problem, causing municipal bonds to be mispriced and undervalued and costing mutual fund shareholders and taxpayers billions of dollars.
Market with your brand, set, go
At the close of each business day, billions of dollars of municipal bonds are “marked to market,” that is, the bond’s closing price that day. If you own shares in a municipal bond mutual fund, the prices of the bonds determine the fund’s net asset value and, in turn, the value of your shares.
Determining the value of a bond is not that complicated; It all depends on the equity that a first year MBA student learns. The structure of each bond—coupon, maturity, redemption features—may change variables slightly, but the fundamentals are the same.
While bond accounting is not unique to the municipal bond market, this market is politely referred to as a “structural problem” that affects fair value.
What is a structural problem? With more than 50,000 municipal and state authorities on $3.9 trillion in outstanding debt and more than 1 million outstanding bond series, there are many bonds available for trading. Additionally, the Municipal Securities Regulatory Board’s 2021 Fact Book states that average daily fixed rate bond transactions in 2021 were 28,985, with a total value of more than $6,200.9 million. Year to 2022 numbers based on the same metrics saw $2,350.8 million in equivalent transactions. There is no trade-off to establish prices, right?
In fact, very few of these billions of dollars are traded in bonds. Most of them sit “in the vault,” as the market says, quietly paying interest until their maturity date.
Even if you take all those $6,200.9 million worth of transactions in 2021, they account for just 0.16% of all outstanding bonds. Price discovery in “direct trade” is extremely limited. And it gets worse. Those are not special bond transactions; If a block of bonds of $1 million trades three times, it is considered a relative trade of $3 million.
On top of that, the driving value of trades is almost entirely “institutional” block sizes—trades of $1 million or more. In the year The average daily fixed-rate volume of block transactions of $1 million or more in 2021 was $3,958.3 million. Even with the multi-trade account problem, this is only 0.10% of the total debt in the market.
Therein lies a structural problem: At least 99% of the market’s $3.9 trillion debt has no trades to guide pricing.
This is why the valuation method based on trades is so problematic. Independent pricing services like Bloomberg and IDC work tirelessly to develop and refine complex quantitative methods to attack this. However, the lack of price discovery from direct transactions cannot be easily corrected for most outstanding bonds.
Similarly, the so-called “fair market value” of billions of dollars of bonds, the net asset values of dozens if not hundreds of mutual funds, and the values of stocks held by millions of investors are determined by statistical sophistication. Assumptions. Not surprisingly, observers both inside and outside the municipal bond market have described the pricing as a lack of transparency.
All this attention is misdirected energy focused on extracting little marketing information. There are many applications and computer systems that, in milliseconds, change prices based on interest rate movements. Pricing based on trades can be opaque, but this part of bond pricing is crystal clear.
The real issue for regulators, investors, issuers and taxpayers is evaluating the credit risk component of municipal bond pricing. There is no ready-made formula here, but there is a wealth of financial data reported regularly from large and small issuers across the country, unlike businesses. Applying this data to assess and measure credit risk translates precisely into better pricing and better liquidity.
Triple-A strength and stability
Credit strength is what sets the municipal bond market apart from others. Compared to the institutional or structured fixed income markets, the market’s high creditworthiness provides investors with some of the most stable and reliable fixed income investments available, both domestically and internationally.
Here is the proof. to Azure US Public Finance US Municipal Bond Defaults and Recoveries, 1970-2020 Moody’s Investor Service publishes it annually. The source of this longitudinal study tracked default data on 13,706 investment-grade bonds, with a five-year cumulative default rate (CDR) for investment-grade municipalities of 0.04 percent. Having an investment grade bond default is about the same as your chance of being struck by lightning. Even the theoretically “riskiest” investment-grade bond, the 10-year aggregate default rate backed by competitive corporates, was a paltry 0.23 percent.
Given this unknown credit risk, one must ask the question: Is the spread of risk in municipal bond prices fair? Put another way, based on the numbers, the basis point difference between the AAA-benchmark curve and the yield on the bond should be negligible for 99 percent of every investment-grade municipal bond.
Consider this and it becomes abundantly clear: Most of the investment-grade bonds currently at risk have their investment-grade CDR, or sector default value, wrong and undervalued.
Even if this saved one basis point of risk spread across 95% of investment-grade bonds, the gains for investors and savings for issuers would exceed $3 billion. Two starting points of savings are pushed to $7 billion. You can do the math from there.
Of course, these may seem like broad conclusions based on the data. To prove his point, he would do well to have a well-organized database containing all the financial information disclosed by most of the 50,000-plus municipal bond borrowers. With such a robust database, financial metrics can be easily searched, sorted, analyzed and compared to find the best deal on Amazon.
With robust, evidence-based data, risk distribution values can be established with greater transparency and objectivity in market and pricing services. With this improved information comes improved liquidity. An efficient market is a lubricant of information.
Trap fair value
Sounds great, right? Even better, there’s all this financial information. Except for one big hitch. It’s captured in that decades-old technology, PDF. PDF is not data. It’s pixels. Not structured data. You cannot download it to a spreadsheet. To get this financial information, you must enter it all manually, if it is on the municipality’s general annual financial report or authority’s balance sheet and income statement.
Included in all this suppressed information is billions of dollars in trapped fair market value.
Financial reporting: digitized and machine-readable
The Financial Information Transparency Act (S. 4295 – “FDTA”), pending before the Senate, provides an easy-to-use solution for free access to information that is widely available and used. In doing so, the FDTA expands machine-readable, digitized financial reporting. This law is potentially transformative for the $3.9 trillion municipal bond market, based on fully current data that has already been sought, collected and made freely available to anyone. Standards for public companies in the US and the rest of the world will bring access and transparency to government financial reporting that is unprecedented in the public sector.
All of these cosponsors of the legislation, US Senators Mark R. Warner (D-VA) and Mike Crapo (R-ID), introduced the bill. FTDA provides investors and consumers with greater transparency and ease of use, as well as streamlined information provision and compliance for our regulated entities. Senator Crapo said the bill would be an important step in “making financial information used by federal regulators more accessible and accessible to the American public” as well as “improving government transparency and accountability.”
All this means that financial information from cities and towns and authorities – assets, liabilities, tax and fee income, cash flow and so on – can be easily downloaded or uploaded to a spreadsheet and managed like any other collection. of numbers.
But what it really means is billions of dollars in guaranteed fair market value to investors and billions of dollars in interest to municipal borrowers.
And who doesn’t want more money?