In a market where at least 99% of trillions of dollars of fixed income securities have no trades to offer price discovery and the financial data to assess credit risk cannot be readily downloaded to a spreadsheet for analysis and comparison, how can there be “fair market value” in pricing?
That question has vexed investors, issuers, and regulators in the $3.9 trillion municipal bond market for decades. The market’s lack of trade data is only matched by its lack of digitized financial data. This “dual data void” compounds the problem, causing municipal bonds to be mispriced and undervalued and it costs mutual fund shareholders and taxpayers alike billions of dollars.
On Your Mark to Market, Get Set, Go
At the close of every business day, billions of dollars of municipal bonds are “mark to market”, that is, valued at the closing price of the bonds that day. If you own shares in a municipal bond mutual fund, the prices of those bonds determine the net asset value of that fund and, in turn, the value of your shares.
Determining the price of a bond is not that complex; it’s all based on an equation that every first-year MBA student learns. Each bond’s structure—coupon, maturity, redemption features—may change up the variables a bit, but the fundamentals stay the same.
While the bond math is no different for the municipal bond market, this market has what is politely called a “structural problem” that affects accurate valuation.
What’s the structural problem? With $3.9 trillion of outstanding debt of over 50,000 municipal and public authorities with over 1 million separately identified bond series, there are plenty of bonds to trade. Moreover, the Municipal Securities Rulemaking Board’s 2021 Factbook notes the average daily number of fixed rate bond trades was 28,985 in 2021, totaling more than $6,200.9 million par value. Based on year-to-date 2022 numbers from those same metrics, some $2,350.8 million par trades have taken place. No paucity of trades to establish prices, right?
In reality, very few of those billions of dollars of outstanding bonds actually trade. Most of them sit “in the vault” as the market saying goes, quietly paying interest until the end of their maturity days.
In fact, even if you take all those $6,200.9 billion par value trades in 2021, they only make up 0.16% of all outstanding bonds. Price discovery by “live trades” is extremely limited. And it gets worse. Those are not unique bond trades; if a single block of $1 million bonds trades three times, it counts for $3 million in par trades.
On top of that, the trades driving pricing are almost exclusively “institutional” block sizes—trades of $1 million-or-greater. In 2021, the average daily fixed-rate par amount of $1 million-or-greater block trades was $3,958.3 million. Even with the multiple-trade accounting problem, this is a mere 0.10% of the total outstanding debt in the market.
Therein lies the structural problem: at least 99% of the market’s $3.9 trillion outstanding debt have no trades to offer pricing guidance.
That’s why a valuation methodology based on trades is highly problematic. Independent pricing services such as Bloomberg and IDC work tirelessly developing and refining a complex web of quantitative methodologies to attack this. However, the lack of price discovery from live trades on the vast majority of outstanding bonds simply cannot be fixed.
Correspondingly, the so-called “fair market valuation” of billions of dollars of bonds, valuations setting the net asset value of dozens if not hundreds of mutual funds, valuations determining the prices of shares held by millions of investors, are determined by statistically sophisticated estimates. No wonder observers both inside and outside the municipal bond market refer to its pricing as opaque.
All this focus on extrapolations from scant trading data is misdirected energy. There are numerous applications and computer systems with the ability to calculate, in milliseconds, changes in prices based on interest rate moves. Pricing based on trades may be opaque, but this part of bond pricing is as clear as glass.
For regulators, investors, issuers, and taxpayers, the real issue is fair valuing the credit risk component of municipal bond pricing. Here there is no ready-made formula but, unlike trades, there is copious amounts of regularly reported financial data from issuers large and small across the nation. Applying this data to assess and quantify credit risk translates into better pricing and better liquidity more accurately.
Triple-A Strength and Stability
Credit strength is where the municipal bond market distinguishes itself from all others. Compared to corporate or structured fixed income markets, the high creditworthiness of the market’s borrowers offers investors some of the most stable, safest fixed income investments available, both domestically and globally.
Here’s the proof. Turn to the US Public Finance US Municipal Bond Defaults and Recoveries, 1970-2020 report Moody’s Investor Service publishes annually. The venerable source of this longitudinal study tracked default data on 13,706 investment-grade rated bonds, determining the five-year Cumulative Default Rate (CDR) for investment-grade municipals was 0.04%. Having your investment-grade rated bond default is nearly the same as your odds of being struck by lightning. Even the 10-year cumulative default rate on theoretically “riskier” investment grade bonds backed by Competitive Enterprises was a meager 0.23%.
Given this nearly undetectable credit risk, one has to ask the question: are risk spreads in municipal bond valuations accurate? Put another way, based on the numbers, the basis point differential quantifying the risk spread between a AAA-benchmark curve and the yield on the bond should be negligible for nearly 99% of every investment grade municipal bond.
Keep thinking this through and it becomes abundantly clear: the vast majority of investment grade bonds currently valued at a risk spread greater than their investment grade CDR or sector default rate are mispriced and undervalued.
Even if this saved just one basis point in risk spread across only 95% of investment grade bonds, the gains to investors and savings to issuers exceed $3 billion dollars. Two basis points in savings push that to $7 billion. You can do the math from there.
Granted, these may seem broad conclusions based on the data. To prove the point, it would be best to have a well-categorized database with all the financial information disclosed by most of the 50,000-plus municipal bond borrowers. With such a robust database, financial metrics could be as readily searched, sorted, analyzed, and compared as one looks for the best deal on Amazon
With hard, evidence-based data, risk spread values could be established by the market and pricing services alike with more transparency and objectivity. Along with this improved data comes improved liquidity. The lubricant of an efficient market is information.
Trapped Fair Value
Sounds pretty good, right? Even better, all this financial data exists. Except with one huge hurdle. It is trapped in that decades’ old technology, the PDF. The PDF is not data. It is pixels. It is not structured data. You cannot download it onto a spreadsheet. To get at this financial data, whether it is in a municipality’s Comprehensive Annual Financial Report or an authority’s Balance Sheet and Income Statement, you have to enter it all by hand.
Embedded in all this trapped data are billions of dollars of trapped fair market value.
Financial Reporting: Digitized and Machine-Readable
The Financial Data Transparency Act (S. 4295 – “FDTA”), pending before the Senate, offers a readily available solution to free that information, making it widely available and usable. In doing so, FDTA expands the adoption of machine-readable, digitized financial reporting. Wholly based on existing information that is already required, collected, and making it available to anyone for free, this legislation is potentially transformative for the $3.9 trillion municipal bond market. It ushers in access to and transparency in government financial reporting that, while the standard for public companies in the U.S. and the rest of the world, is unprecedented in the public sector.
All of these are why the co-sponsors of the legislation, U.S. Senators Mark R. Warner (D-VA) and Mike Crapo (R-ID) introduced the bill. FTDA provides “greater transparency and usability for investors and consumers, along with streamlined data submissions and compliance for our regulated institutions,” offered Senator Warner. Senator Crapo noted the bill would be an important step forward in “making financial data used by federal regulators more accessible and accessible to the American public” as well as “improving government transparency and accountability.”
All this boils down to is that the financial information available from cities and towns and authorities—assets, debts, tax and fee revenues, cash flows, and so forth—can be easily downloaded or uploaded into a spreadsheet and treated just like any other bunch of numbers.
But what it really means is billions of dollars of realized fair market value for investors and billions of dollars of interest savings for municipal borrowers.
And who doesn’t want more money?