Bridging the wholesale – retail market divide

One of the most difficult issues related to improving the structure of bond markets for retail investors is that wholesale trading happens entirely apart from retail trading. Retail investors suffer because they pay much higher prices than institutions do. This differs from equities markets where every investor, large or small, can buy a share of Google at the same price at the same time.

In muniland, we have institutional trading platforms like Tradeweb and MarketAxess and retail platforms like Bonddesk and The Municenter that execute “odd-lot” trades or generally those under $100,000. Institutional trading desks and platforms typically execute orders over $1 million and the two pools of trading don’t interact. This structural difference creates two sets of pricing; one with thin spreads for institutional clients and the other with enormous bid/ask spreads for retail clients. 

Two tiered bond pricing differs from the equity market where buyers and sellers of all sizes meet at the same place via the consolidated trade and quote tapes. For equities, institutional and retail size bids and offers flow onto the consolidated tape. These are aggregated by various systems into central order books. You can see all bids and offers at a certain level and their size. This helps pricing for a security remain in lockstep regardless of the trade size. There is no equivalent in muniland or the corporate bond markets. For most of the bond market this would be hard to do because individual securities trade so infrequently. But one part of the bond market is liquid enough to mimic the way equity pricing systems work. This is the $16 trillion U.S. Treasury market, the most liquid bond market in the world.

The Australian government has set up a system, as you can see below, for Australian Government Bonds (AGB) that blends their institutional trading market with their retail market via the Australian Stock Exchange (ASX). The government established a set of regulations for dealers to act as AGB intermediary market-makers between the wholesale AGB over-the-counter market and the ASX. 

In essence an AGB is split into smaller parts, and retail investors buy a “share” or part interest at the wholesale price of the bond. The retail investor receives a prorated share of annual interest and principal when the bond matures. It’s a hybrid solution to the two-tier market problem. 

Puerto Rico’s borrowing goes private

Barron’s ran a cover story last week and more articles followed in the financial press about the economic disabilities of Puerto Rico. These disabilities have been fueling a sell-off of the commonwealth’s public debt. Here is a chart showing the spread (or extra yield) that Puerto Rico bonds have had over the last three months:

You can see that the 20 and 30-year bond spreads have been rising since early June in a consistent pattern. This may be related to mutual funds selling their long Puerto Rico bonds. Thomson Reuters Municipal Market Data senior analyst Daniel Berger describes the situation:

Because Puerto Rico bonds are triple tax they are widely held by some well-known mutual funds. The wider spreads in these names have lowered prices of these muni mutual funds that rely on Puerto Rico bonds for higher income (very important in a low interest rate environment.)

A fund manager looks over muniland

Here is a broad sweeping statement for you: there is a lot of group-thinking in all markets, and when I talk to participants far outside of New York, I tend to find their thinking more individual and reasoned. I recently chatted with Jeffery Elswick of Frost Investment Advisors’ Total Return Bond Fund, who is based in San Antonio, Texas. The fund is generally classified as a core, intermediate investment grade bond fund that buys all kinds of bonds, including taxable munis. Morningstar gives the fund five stars.

Here is some of our chat:

Cate Long: Do loads on retail mutual fund share classes slow down redemptions?

Jeffery Elswick: That is an interesting question and logically it should, but I’m not sure that retail investors take it into account when selling bond funds.

CL: Do the big dealers running thinner trading books have an effect on your redemption strategies?

Alternative trading system BondDesk up for sale

Reuters reported this week that the retail focused corporate and municipal bond trading platform BondDesk is up for sale:

Institutional fixed-income trading platform providers Tradeweb and MarketAxess are among three bidders for BondDesk Group LLC in a deal that is expected to be valued up to $200 million, two sources familiar with the situation told Reuters this week.

Disclosure: Thomson Reuters is the majority owner of Tradeweb.

BondDesk was founded in 1999 by Charles Almond who, with Paine Webber (which became UBS), formed the first bond aggregation platform for odd-lot or retail sized trades.

Detroit’s pension math

A lot of ink has been spilled over the assertions of Kevyn Orr, Detroit’s emergency manager, on the level of funding in Detroit’s pensions (Okay, I might be the leader of that pack). The issue has bearing on the benefits that Detroit’s retirees will receive, as well as how much cash-flow the city will have to service its bonds and other debts. The pension question is a major point in Detroit’s bankruptcy negotiations. Reuters described the situation like this:

Detroit’s largest unsecured creditors are its two pension funds, which have claims totaling nearly $3.5 billion in unfunded liabilities, according to a city estimate included in a bankruptcy filing. Pension funds and unions dispute the estimate, claiming Orr has overstated the underfunding.

Orr has said he based the city estimate on ‘more realistic assumptions’ than previously used. His figure is five times more than the $644 million gap the pension funds reported based on 2011 actuarial valuations.

What happened to Chicago’s bonds?

Last week, on August 23rd, an unlimited tax general obligation bond for Chicago  had a disastrous performance.

The bond (Cusip 167486PS), was issued in 2012 and matures in 2032. The original offering was for $594 million. The piece in discussion was $1.65 million (big bond offerings are usually chopped up into smaller pieces with different characteristics and maturities). The yield on the bond (rated A+ by Standard & Poor’s and AA- by Fitch) was 5.94 percent on August 23, or over 10 percent on a fully taxable equivalent basis. Is Chicago really this risky? What is going on?

I pulled the average yield for comparable New York City bonds. The bonds, which are rated Aa2 by Moody’s and AA by Standard & Poor’s (approximately two notches higher than Chicago’s bonds), were yielding 4.66 percent for 2032 maturities on the same day. This is a 1.28 percent difference (128 basis points in bondtalk). Chicago bonds are selling pretty cheap.

In Detroit, were Orr’s pension estimates in ‘good faith’?

On June 14th, when Detroit emergency manager Kevyn Orr released his creditor proposal detailing how he wanted to treat creditors of the city, including retirees, I was aghast. Orr’s report said that the city’s pensions, which have been listed as exceptionally well-funded for years, were suddenly in desperate shape. What had been the one strong piece of Detroit’s balance sheet was suddenly reported to face medium-term collapse. Was there securities fraud in the financial reporting or had the investments in the pension funds blown up?

I’ve written numerous times that Orr likely over-inflated the pension liabilities.

We now have analysis from Morningstar that shows Orr probably did overstate Detroit pension liabilities by at least $1.5 billion. The Morningstar analysis is based on the recently released report that Orr commissioned from the actuarial firm Milliman.

Harrisburg deserves a bright future

A debt recovery plan for Harrisburg, Pennsylvania was filed on Monday after a year of negotiations with creditors, unions and other stakeholders. The plan’s most important attribute is that it saves Pennsylvania’s capital city from declaring bankruptcy and it may fiscally stabilize the municipality for years to come.

The plan includes an extension of maturity of general obligation bonds and a reduction in labor costs through 2016. The city will still be responsible for substantial payments on its general obligation bonds. In 2013, the debt payment is set at $5,970,000 and at $7,670,000 for every year from 2014 through 2016.

The receiver has estimated that the city will also pay $3 million per year from 2013 through 2016 on existing loans or leases for equipment and short-term borrowings. This equals about 17 percent of the estimated general fund revenues of $60 million for 2014. This is a crushing debt burden for any municipality, but projections show it is sustainable through 2016 (page 73).

Wobbly muniland markets

Just some chart play today. Notice all the weak spots.

Chart 1 and 2 are from Morgan Stanley’s August Municipal Bond Monthly.

S&P Muni Index data is here.

Check me out on Reuters Insider. Insider is a free Thompson Reuters video service for finance professionals covering multiple asset classes.

An appeal to President Obama as he goes to Scranton

President Obama and his entourage are pulling into Scranton, PA for a speech on Friday. In many ways Scranton is the east coast equivalent of Detroit; a former industrial powerhouse reduced to the economic wilderness. The city’s unemployment rate was 9 percent in April 2013. Scranton almost ran out of cash last summer and the mayor reduced everyone to minimum wage to meet payroll.

The city of 76,000 has defaulted on contracts that can lead to loan defaults and is deficit borrowing at extremely high rates. It’s been in the state fiscal distress program for over two decades. The city has finally taken steps to right its fiscal ship. But it had to fight public unions tooth and nail to alter their path (page 14):

The full implementation of the 2002 Recovery Plan was never fully realized due to the opposition from the public safety unions of the City. The public safety unions sought Act 111 binding arbitration proceedings to challenge the 2002 Recovery Plan. After years of legal proceedings relating to the arbitration awards, the Pennsylvania Supreme Court ruled in late 2011 in favor of the public safety unions, overturning prior appellate court decisions.

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