Municipal bond price transparency: what it means for issuers.

• Author: Ruth, Heather L.

New initiatives to provide information on municipal bond transactions and prices will benefit issuers as well as investors and lead to higher volume and greater liquidity in the municipal bond market.

The municipal bond market is undergoing dramatic changes today. A wave of information about bond prices and the financial condition of issuers is roiling the traditionally calm waters of tax-exempt finance and investing. Much of the change is generated by industry-supported regulations on disclosure in the secondary market. As market participants scramble to get ahead of the wave, many observers foresee a stronger secondary market for tax-exempt bonds, increased liquidity, and potentially lower financing costs for issuers.

Although much of the recent attention among market professionals has focused on the Securities and Exchange Commission's (SEC) new rule 15c2-12 enhancing secondary market disclosure, parallel developments related to "price transparency" may have an equally profound impact. Price transparency includes a number of independent initiatives, one led by the Municipal Securities Rulemaking Board (MSRB), the industry self-regulatory organization, while two others are sponsored by municipal securities dealers through the Public Securities Association (PSA).

Individual Investor Market

What makes price transparency so important? The answer is apparent only if one understands the distinctive nature of the municipal bond market. It begins with individual investors, who make up the largest portion of municipal bond holders. Until the mid-1980s, commercial banks represented the lion's share of bond purchasers, but changes in federal tax law removed incentives for banks to invest in municipals. As a result, bank holdings have dropped substantially, and individuals now constitute the largest group of bond investors, holding almost 70 percent of municipal debt directly or through bond funds and unit investment trusts. The Federal Reserve calculates that direct holdings of tax-exempt bonds by "U.S. households" (versus funds, banks, insurance companies, or other entities) account for $370.3 billion of the $1.16 trillion market.

In the past, these individual investors have had little direct access to information about bond market values. When the time came to buy or sell a municipal bond, they obtained most of their information, including daily price quotes and yields, from one or more brokers. Investors who sought to follow the changes in prices and yields of a single bond or a portfolio of bonds, just as they might follow their stock portfolios, usually could not do so without going to a broker. Why? Unlike exchange-traded markets, which report a single daily price for each security, the municipal bond market is an over-the-counter (OTC) exchange with market makers competing with each other to obtain the best price for themselves and for their customers. Different brokers may quote a slightly different price for the same bond, depending partly on a complex set of valuation factors to be discussed below.

Another distinctive feature of the municipal bond market: there are no newspaper listings of individual prices. That is no great surprise when one considers that a complete table of all 1.5 million outstanding municipal bonds would fill approximately 90 full pages in a newspaper. The absence of municipal market data in statistical listings carries over into the editorial coverage: despite the empirical evidence that many newspaper readers probably own municipals, most personal finance and investment stories tend to ignore tax-exempt investing. In a sampling of the 20 largest metropolitan newspapers conducted earlier this year, only seven published municipal yield tables while only one, The Columbus Dispatch, featured a weekly column devoted to the municipal market.

The municipal market has another characteristic that has made it difficult for investors to obtain price information: comparatively low trading volume. Most investors buy municipal bonds and hold them until maturity. As a result, estimated daily trading volume is $3 billion, versus $10 billion for equities and $10 billion to $15 billion for corporate bonds. In a market that has relatively few transactions, as well as a vast number of securities that trade only rarely, the most definitive indication of current value--a current or recent transaction--simply may not exist.

Pricing Information Sources. Traditionally, the retail brokers who quote prices...