Understanding the secondary market
In 1995, the primary market in municipal securities did nearly $160 billion worth of business. Current estimates of die amount of daily trading on the secondary market range upwards of $3 billion a day.
This is no real surprise to those whose business is municipal securities.
Why then, do more local government finance directors pay so little attention to this aspect of the business?
“I have actually heard some finance directors say `Why should I care about the secondary market?”‘ says Caroline Benn, PSA’s senior vice president of communications. “Their attitude is that people should buy securities and hold them until they die. But that is not realistic. People are not going to invest in something they can’t re-sell.”
The secondary market is the primary avenue for investors who want to convert their investments into cash. In recent years, the secondary market has taken on a life of its own, especially since 1994, when the Securities and Exchange Commission tightened up disclosure requirements that forced issuers to provide detailed information about anything that could affect the financial health of the bonds they issue.
Disclosure requirements hit cities and counties hard, because they were finally being forced to acknowledge what they previously might have tried to gloss over or ignore altogether. Additionally, local officials complained that disclosure represented yet another unfunded mandate.
Still, it was partly because of a lack of this kind of disclosure that several bond, holders with Washington Public Power Supply System securities lost a fortune when the agency defaulted on $2.25 billion worth of its debt.
Those securities, which were bought on the secondary market, might have been red-flagged had disclosure regulations been in force.
The municipal bond market is really big business. In fact, it is characterized by the huge number of issues for which it is responsible.
Additionally, a number of peculiarities set the municipal bond market apart from the markets in other securities, like stocks. For one thing, nearly all transactions in municipal bonds are principal or dealer transactions, as opposed to transactions between two parties with a firm acting as agent.
Furthermore, there are no set trading hours for muni bonds; most are traded on the basis of yield, and all trades are over-the-counter, meaning that trading is of the normal “bid-and-offer” type, — investors may bid for securities at a higher yield and, therefore, a lower price. A cogent discussion of the procedure appears in Fundamentals of Municipal Bonds, possibly the definitive work on the subject, published by the PSA.
Two factors — market risk and credit risk — are most responsible for the price of muni bonds on the secondary market. The former is influenced by price fluctuations due to changes in the general level of municipal interest rates; the latter measures the risk associated about with the creditworthiness of an individual issue and issuer. The worth of a specific bond, then, is tied not only to the market for all other muni bonds, but also to economic up- and downswings that may affect a city’s overall credit rating.
The PSA book points out that some New York City issues fell by 300 basis points to 400 basis points during the city’s 1975 financial crisis. The book also notes that such a drastic drop is highly unusual.
Substantial changes in the types of investors in municipal securities have taken place over the past two decades. In the 1970s, the vast majority of muni bondholders were property and casualty insurance companies and banks. Just a fraction of the securities were held by mutual funds.
By the mid-1980s, the tax advantages for banks had diminished.
In 1980, for example, individuals held 26.2 percent of the municipal securities, and commercial banks and property and casualty insurance companies held 37.3 percent and 20.2 percent, respectively, according to PSA figures. Just 8.1 percent was held in fund and trust portfolios.
By 1995, individual investors held 33.4 percent of municipal securities, funds and trust portfolios 39 percent, commercial banks 7.2 percent and property and casualty insurance companies 12.6 percent.
Because banks and insurance companies are much more likely to buy and hold securities for a period of time, while mutual funds are subject to unpredictable demands for redemptions, the reversal in the numbers meant a more active secondary market. “Nearly three-quarters of the holders of munis care a lot about being able to buy and sell bonds in a secondary market,” Benn says.
These dramatic changes have market observers looking at the secondary market, according to PSA President Heather Ruth, who, in an article for Government Finance Review, predicts a much stronger secondary market because of the changes.
Still, its importance has gone largely unrecognized by many local government finance directors.
“The secondary market is not as well understood [as the primary market] by issuers,” says Steve Schrager, vice president and assistant director of investor relations in the public finance department at Moody’s Investors Service in New York. “But it’s intricately related. The bonds that trade better on the secondary market are the bonds people know more about. So it’s to a city’s advantage to follow its bonds and make sure that information about them is available. That way the market is kept liquid, and the next time the issuer comes to the market in a primary deal, there is better acceptance.”
There are, according to Benn, two major reasons that issuers should interested in the secondary mark First, an active secondary mar means that issuers can issue bonds lower yields. Second, it expands demand for those bonds and allows issuers to diversify their customer base. According to Benn, issuers who are very active in the primary market are much more attuned to importance of the secondary market. “But some issuers who are in the market once every five years don’t think they need to worry about the secondary market,” she says. “Their attitude is `Look, I can provide the information when I come to market, and as far as I’m concerned, that’s it.’ But that’s really not a viable option anymore. People who buy securities, like stocks, for instance, are used to getting information about the value of those securities. All sorts of material information that affects the price of bonds can change over a five-year period. There needs to be greater awareness of investor needs on the part of issuers.”
That is coming, according to Cathy Spain of the Chicago-based Government Finance Officers Association (GFOA). She credits both the new disclosure rules and the advances in technology with piquing issuer interest in the secondary market. “For the first time, she says, “there will be data about how bonds are traded in the secondary market. Also, the whole Internet explosion will have an effect. Between the new technology and the new information available, people are going to begin to think differently about their bonds.”
Lynn Hampton is a believer, one of those who has always seen the value of following the secondary market. The chief financial officer of the Alexandria, Va.-based Metropolitan Washington Airports Authority, Hampton says the more investors understand about the authority’s bonds, the more they like them. That’s why the authority has an investor relations program charged with sending out regular financial statements and newsletters. “We want to stay in touch with our bondholders,” Hampton says. “We like knowing who owns our bonds.”
The authority, which has $1.3 billion in outstanding debt, regularly invites those bondholders to functions like ribbon-cuttings. “It’s marketing,” Hampton says. “If we communicate with our bondholders, we hope that next time. we want to sell bonds, they’ll be happy with us.”
The GFOA definitely believes in the value of investor relations programs; so much so that it has put out a recommended practice about them. “A good investor relations program forces people to think about investors in a more formal way,” Spain says.
According to the GFOA, when considering designing an investor relations program, issuers should identify the individual responsible for speaking on behalf of the issuer to the market; determine what information will be disclosed or made available and the procedures for disseminating this information to investors; develop a process to ensure financial statements and other material are completed on a consistent schedule; establish internal procedures for dealing with investors; and establish policies and institutional procedures to ensure that conduit borrowers meet their disclosure obligations.
For more information, see Fundamentals of Municipal Bonds, Fourth Edition, published by the Public Securities Association, (212) 440-9400 or contact the PSA at 40 Broad Street, 12th Floor, New York, N.Y. 10004-2372; http.// www.psa.com. The GFOA can be reached at (312) 977-9700.