This is certainly not the kind of week that bond traders want to step in front of: between the monthly meeting of the Federal Open Market Committee (affectionately dubbed the “Federal Open Mouth Committee” by some of our friends in the business) and another employment data watch, there is definitely potential for increased volatility as the week unfolds.
Lurking in the background is the looming competition between Larry Summers and Janet Yellen as potential replacements for Ben Bernanke. Already, the common wisdom has Yellen pegged as the champion of “continuity,” while the mercurial Summers has been cast as a policy wild card.
In the meantime, softening consumer confidence and growing expectations that Q2 GDP will come in at less than 1% have combined to give the government debt market a slightly positive bias. At this writing, 10-year and 30-year Treasuries are hovering around 2.58% and 3.65%, respectively.
After a solid bounce of about 10 basis points last Friday, the tax-exempt market is largely in standstill mode as it braces itself for yet another week of mutual fund outflows, driven by July’s projected negative returns.
New Issue Market
The municipal new issue calendar continues to dwindle this week, with just over $4 billion slated to be priced. Even then, the bulk of the new supply is accounted for by a $1.1 billion Ohio Transportation deal and $600 million Massachusetts G.O.s. Neither deal is expected to re-energize secondary market trading activities ahead of the July employment release on Friday.
Looking further ahead, the Commonwealth of Puerto Rico is scheduled to return to the market in mid-August with a $600 million issue for its electric power agency, PREPA. This is the Commonwealth’s first foray into the market since the June meltdown, so it made sense to test investor appetite with its highest-rated agency after COFINA. Since Puerto Rico paper has been tightening against the general market in recent months, we would expect PREPA to be priced in the +225-250 range versus AAA. More on this as we get closer to the actual pricing date.
The Challenges of Muni Price Discovery
This morning’s Wall Street Journal highlights a problem endemic to the municipal market: the absence of price transparency and the dearth of price discovery tools, particularly for retail investors. In an over-the-counter market such as munis, a simple question such as “what are my bonds worth?” doesn’t always get a simple answer. And the answer may also differ depending on whether you’re an institutional or a retail investor.
In an article titled: “Search for Muni-Bond Guidepost Sputters,” the Journal discusses the Municipal Securities Rulemaking Board’s (MSRB) current efforts to develop a standard yield benchmark for individual investors.
According to the Journal, “the MSRB, a self-regulator overseen by the SEC, wants a third party to develop a benchmark. But SEC officials are concerned such outsourcing could allow for manipulation and result in the MSRB inadvertently giving a regulatory stamp of approval to a faulty benchmark”. Apparently, the MSRB has been working with Municipal Market Data (MMD), a Thomson Reuters unit, to develop this price discovery tool. MMD is already providing daily benchmark yield curves for institutional players and others who can afford access to its tm3.com service.
Although MMD has, in our opinion, always done a creditable job, many market participants still knock its methodology as largely “subjective”, since it is partially based on daily verbal input from key market participants. In the wake of the LIBOR scandal, any benchmark that is not purely derived from objective trade data, to the extent they are available, might be viewed with suspicion by regulators.
Having access to the correct AAA curve still won’t guarantee you will get to the correct price. In our view, the pricing services are actually the ones who play a critical role in the price discovery process. In my recent book on the high yield market, I pointed out that one of the muni market’s dirty little secrets is how dependent market participants are on the bond evaluations provided by third party pricing services. Since only a fraction of all outstanding municipals actually trade on any given day, firms such as Standard & Poor’s Capital IQ (formerly known as J J Kenny) and Interactive Data Corp. (IDC) must bridge the gap between where a bond traded in the past and what it might be worth today. On the institutional side, when faced with a bond that has not traded in a while, a trader’s first instinct is to look up the evaluation. Then he or she can decide whether or not to agree or disagree with such evaluation. Unfortunately, the high cost of accessing this pricing information puts this tool out of reach for most retail buyers. This suggests the MSRB might be better off directing its efforts toward providing fair market evaluations to the retail public, instead of just the benchmark curves.
In the aftermath of the latest bond market selloff, retail investors have reportedly stepped up their participation in the tax-exempt market, even as others continue to cash out of their mutual fund shares. Thus, the need for price discovery and price transparency is more acute now than ever. In response, BondDesk, an electronic bond trading platform, and S&P Capital IQ recently announced they have combined forces to launch an odd-lot pricing service directed at individual investors.
At the end of the day, a benchmark is, by definition, just a starting point for price discovery. Market participants will always adjust yield spreads as they deem appropriate to get to the “correct” final yield or price. So the only real requirement for a sound benchmark is that it should be derived from “objective” data sources, and with a consistent methodology.
Given the massive computing power now available at relatively low cost, we wouldn’t be surprised if someone came up with new technology to reverse-engineer a daily yield curve based on daily trade data, combined with historical spread data. You could even envision a constant feedback loop whereby new trade information throughout the trading day would go into improving the accuracy of the existing curve. Manual intervention would be required only to the extent needed to identify outlier trades. Now there’s a potential opportunity for all you technology entrepreneurs out there.
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