GLOBAL INVESTING: Exploring the dark side of the Muni

By Jenny Wiggins
Financial Times; Oct 16, 2002

Among the more popular investments in these dark days of financial scandal are municipal bonds. These securities generally carry less risk than corporate bonds and are favoured for their tax advantages - the interest paid on most bonds is exempt from federal taxes.

"Muni demand has been very substantial," says Philip Fischer, a director at Merrill Lynch. "We've had many people talk to us about muni bonds who have never bought them."

Investors have been attracted by the market's good returns, which are around 7 per cent in the year to date, making municipal bonds a better investment this year than most other fixed-income securities.

A third of outstanding US municipal bonds is held directly by retail investors, while another third is owned through mutual funds. More than $10.6bn flowed into municipal bond funds in the third quarter of this year. This is a record amount, as well as being the biggest inflow since 1993's first-quarter influx of $9.9bn, according to AMG Data.

But investors considering buying municipal bonds should be aware of the market's murky history.

The municipal bond market, which has been in existence for about 200 years, has not always been a friendly place for retail investors. It was dominated by institutional investors, statements of primary offerings were all but impossible to obtain and disclosure was "less than desirable", in the words of Arthur Levitt, former Securities and Exchange Commission chairman.

Issuers did not provide disclosure about the condition of bonds, and investors had no easy way of determining the latest prices of bonds once they had bought them. Unlike corporate bond issuers, sellers of muni bonds are not required to file details of transactions with the SEC.

This left the market - characterised by some as "Wild West" - open to abuse. In the 1990s, the SEC delved into dozens of cases involving hidden payment arrangements, conflicts of interest, kickbacks and "yield-burning" - a practice that involved brokerage firms overcharging on Treasury securities purchased with proceeds from the sale of municipal bonds. This jeopardised the tax-exempt status of interest paid to holders of those bonds.

These practices are no longer commonplace, according to Christopher Taylor, executive director of the Municipal Securities Rulemaking Board, which develops rules to regulate firms and banks involved in underwriting, trading, and selling municipal securities. "All of those practices, as far as I know, are gone," he says.

The Municipal Council, a group of bond market participants, is also working on improving financial disclosure for municipal securities and is trying to develop a central place - such as a website - where information on the securities could be filed and accessed by investors.

As part of its efforts to improve pricing transparency in the municipal market, the MSRB now requires dealers to release the trading details of bond transactions more frequently.

Pricing information for bonds traded twice a day must now be released the next day, while pricing for all bonds traded must soon be released one week after the trades take place. The board hopes by 2004 to achieve "real-time reporting", which would require dealers to report trades 15 minutes after they are undertaken. Mr Taylor says that the board is cautious of imposing changes on the market too quickly for fearing of causing "sudden dislocations in the market".

But some market participants complain that progress toward complete pricing transparency is slow. Kevin Olson, a self-described "investor advocate" and founder of the website MunicipalBonds.com, says the MSRB has been "dragging its feet" with regard to improving disclosure, and that he would like pricing information for all municipal securities transactions to be made available on a next-day basis more quickly.

Mr Olson last month filed a lawsuit against several large brokerage firms alleging unfair and unreasonable fees in the sale of municipal bonds. The complaint seeks an injunction against the imposition of the fees. The MunicipalBonds.com website highlights bond transactions in which there is an unusually large spread between bid and offer prices. Wide spreads could reflect illegal price mark-ups, according to Mr Olson.

Lynnette Hotchkiss, associate general counsel for the Bond Market Association, acknowledges that "there may be instances where trades are done with a mark-up that is excessive".

The responsibility of investigating allegations of unfair pricing falls to the National Association of Securities Dealers. It does not comment on current investigations. Fund managers say that improving price transparency in the municipal market is difficult because there are more than 50,000 government entities that issue the securities and about 1.5m separate issues. "The MSRB has done an excellent job of improving the disclosure and improving the transparency," says Jerry Jacobs, chief investment officer of the tax-exempt fixed-income group at Putnam Investments.

Institutional investors say they consider offerings from 20 to 80 dealers when buying municipal bonds, and consequently can avoid dealers that overcharge. But they support attempts to improve transparency. "As a buyer we want as much disclosure as possible," says Mark Stockwell, director of the municipal investment group at PNC Advisors.