Sept. 5 (Bloomberg) -- Why would you buy a municipal bond
with a negative yield?
It happens every day, as Kevin Olson pointed out earlier
this year on his Web site, MunicipalBonds.com.
Olson was outraged by his discovery of negative yields. He
continues to ask on his Web site, ``Aren't negative yields
illegal . or prohibited . or something???''
They're not. Bond traders say there's nothing very
mysterious about these transactions. What the buyers are doing is
purchasing bonds that are callable in a short time, and making an
educated bet that the issuer won't exercise the call.
The negative yield will -- or should -- show up on the
buyer's confirmation, because dealers are required to show
``yield to worst,'' the yield presuming the call will be made.
The yield only remains negative until the call date. After
the date passes, and the call isn't exercised, the yield turns
positive. There's nothing wrong, or illegal about it, and
sophisticated and institutional investors engage in such
transactions all the time.
This is what the market knows, right? Everyone in the
municipal bond market knows all about transactions that result in
negative yields.
Well, perhaps not everyone.
Perhaps not even expert witnesses, as a Securities and
Exchange Commission opinion filed in August makes clear.
`Not on Purpose'
In September 1995, a bond dealer sold an individual investor
a $25,000 block of bonds. The dealer bought the bonds for 107,
and sold them to the investor for 110 3/4.
That's a markup of 3.50 percent, which is pretty good,
especially considering that the dealer engaged in what are called
``riskless principal transactions.'' He only bought bonds when he
knew he had a customer for them.
The markup isn't the interesting part of the SEC opinion.
What comes after this statement about the transaction is.
Because the bonds had a call date of Nov. 1, 1995, the
resulting yield to the customer was negative 42.95 percent. The
SEC's expert witness ``considered this trade to be highly unusual
because `nobody buys bonds with a negative return to maturity, at
least not on purpose.' ''
Highly unusual? Nobody buys bonds with negative returns on
purpose?
The tale of buying bonds with negative yields was just a
nugget contained in the SEC's opinion, ``In the Matter of Mark
David Anderson of Marina Del Rey, California.''
Markups, Markdowns
Perhaps the widespread buying of bonds producing negative
yields, at least for a little while, is more widespread today
than it was in the mid-1990s. Or perhaps it's not as widespread
and common as some traders think it is.
The comment on negative yields in the SEC opinion counts as
only an aside, albeit a curious one. The opinion is really all
about ``excessive markups and markdowns'' on bonds.
The Municipal Securities Rulemaking Board, which oversees
the municipal market, is silent on the matter of markups and
markdowns. The MSRB's Rule G-30 only states that a bond's price
should be ``fair and reasonable, taking into consideration all
relevant factors.''
These factors can include such things as the amount of bonds
purchased, credit rating, coupon, and maturity.
Read Footnotes
Dealers have, or have had, a lot of latitude when it comes to
prices. Just how much is becoming debatable. The dealer mentioned
in the opinion charged markups of 1.41 percent to 5 percent, and
markdowns of 3.02 percent to 5.64 percent. Yet the SEC says that
for the transactions it lists, these markups and markdowns
``substantially exceeded accepted industry practice.''
As always, some of the most interesting material is
contained in the footnotes.
Consider this passage: ``Our opinions suggest that although
some markups on municipal bonds may reach 5 percent, that figure
might be acceptable in only the most exceptional cases,'' the SEC
says. Markups from 4 percent to 5.9 percent on municipal bonds
might well be deemed ``improper.''
Which all suggests that the SEC is thinking that markups and
markdowns should be a lot lower than some dealers do. The SEC
hasn't commented on negative yields.
