The path to bond market efficiency: how increased retail distribution can lower borrowing costs.

• Author: Heppenstall, Jr., C. Talbot

Government entities all share one key objective when issuing municipal bonds: to receive maximum proceeds at the lowest possible interest rates and fees. This result is best assured by the deepest possible sales penetration to every interested buyer. However, the Municipal Securities Rulemaking Board's comprehensive trade data shows that on average, issuers miss almost 60 percent of retail buyers for their deals. This type of market inefficiency costs issuers and their taxpayers money.

Federal Reserve data confirms that retail investors (households) collectively make up the largest group of municipal bondholders. As Exhibit l shows, retail investors comprise almost 35 percent of the total par amount of municipal bonds sold by broker-dealers in the municipal bond market and more than 95 percent of total trades. (1) These statistics represent the entire municipal bond market, including both primary and secondary market trades.

Such strong demand for municipal bonds by retail investors would appear to be good news for issuers. However, a closer look seems to suggest otherwise. While retail investors purchased more than 34 percent (or $150 billion) of the total par value of municipal bonds, only $30 billion of these purchases occurred in the primary market, where issuers can realize a benefit. The majority of retail purchases are made in the secondary market at lower yields than primary market yields. This disparity raises an important question: If an issuer's bonds are eventually bought by retail investors, local or otherwise, does it make any difference if the sale happens in the primary or secondary market? The answer is a resounding yes!

Municipal market trading data proves that current market conditions create an inefficient new issue distribution process. When market inefficiencies exist, certain market participants are not getting the best results. In the municipal bond market, issuers are paying higher yields for purchases made at low, wholesale prices, only to have the bonds resold in the secondary market where retail investors purchase them at higher, retail prices. Since issuers do not receive any portion of these higher prices, they miss out on additional proceeds.

THE COSTS OF MARKET INEFFICIENCY

To understand more clearly the costs of market inefficiency, consider the following analysis of a recent municipal bond issue by a large municipality. Although we have changed the issuer's name and the dates of issuance, the data is the actual data from the official statement and MSRB comprehensive trade data. Municipality ABC issued bonds that were underwritten in the primary market by a large syndicate of broker-dealers. For the purpose of illustration and for clarity of analysis, the data focuses on a single $223 million maturity of this bond issue.

In this sample maturity, $81.8 million of bonds were sold in the...