Welcome to the intriguing world of municipal bonds, commonly referred to as ‘Munis’, where the financial realm intersects with the public sector’s funding needs. If you are curious about how municipalities raise capital for critical infrastructure projects, public services, and development initiatives, or are curious about how to gain optimal exposure to the municipal bond asset class, you’ve come to the right place. In this blog post, we will unravel the nuances of trading in municipal securities.
We will discuss primary and secondary markets, as well as the key players involved. You’ll gain insight into the underwriting process and how these bonds are initially offered to investors. Furthermore, we will discuss the secondary market, where already-issued municipal bonds are bought and sold among investors, including the role of brokers, dealers, and electronic platforms.
So, whether you are an investor seeking diversification, a municipal finance professional aiming to deepen your understanding, or simply an individual interested in the intersection of finance and public infrastructure, this blog post can help you navigate the world of municipal bonds with confidence.
The Primary Market:
Raising capital for municipalities involves various players working together to facilitate the financing process. Municipalities include cities, counties, and special districts seeking to raise capital for various public service-oriented projects. The issuer is the specific governmental entity responsible for issuing municipal bonds on behalf of the municipality. These may include state or local government agencies or authorities specifically designed for bond issuance.
Underwriters play a crucial role in the municipal bond issuance process. They are typically investment banks that assist municipalities in structuring the bond offering, determining bond terms, and marketing the bonds to potential investors. Underwriters will typically purchase the bonds from the issuers at a negotiated price and then sell them to investors. Alternatively, multiple investment banks may bid for a bond issue with the highest bidder purchasing the offering to then sell to potential investors. This process is called a “competitive” offering.
Bond counsel consists of attorneys or law firms specializing in municipal finance. They provide legal advice to municipalities throughout the bond issuance process, ensuring compliance with relevant laws, regulations, and tax requirements. Bond counsel also review and approves the bond documents and helps resolve legal complexities related to the issuance.
Municipalities often engage financial advisors, such as investment banks or consulting firms, to provide guidance and expertise in the financing process. They assist in determining the optimal bond structure, analyzing market conditions, and advising on the timing and pricing of the bond issuance. They help municipalities navigate complex financial decisions and ensure the most favorable outcomes for the issuer and investors.
Lastly, we have investors. They include mutual funds, insurance companies, banks, and individuals seeking tax-advantaged income and diversification. Investors provide the capital needed by municipalities, and in return, receive regular interest payments and the return of principal upon bond maturity. Investors may purchase municipal bonds directly from the underwriter or broker-dealer upon issuance.
The Secondary Market
The secondary municipal bond market is where already-issued municipal bonds are bought and sold among investors. It provides a platform for investors to trade bonds after the initial issuance, allowing for liquidity and the opportunity to adjust investment portfolios. The secondary market for municipal bonds operates through a network of broker-dealers and electronic trading platforms, each playing a distinct role in facilitating transactions. As is the case with many municipal bonds, the active trading in specific securities can be intermittent. Sometimes bonds won’t trade for months and even years after they have been issued.
Brokers in the secondary municipal bond market act as intermediaries between buyers and sellers. They connect investors seeking to buy or sell bonds and facilitate the transaction on their behalf. Dealers, on the other hand, are market participants who actively buy and sell municipal bonds for their own accounts. They maintain an inventory of bonds and actively quote bid and ask prices, providing liquidity to the market.
In recent years, electronic platforms have emerged as an increasingly popular venue for trading municipal bonds in the secondary market. These platforms provide an electronic marketplace for buyers and sellers to connect directly. They offer transparency, speed, and accessibility, allowing investors to view real-time prices, submit orders, and execute trades electronically. Electronic platforms also provide access to a broader range of bonds and enable investors to efficiently search for specific bond characteristics and compare pricing from multiple sources.
The secondary market for municipal bonds offers investors the flexibility to buy and sell bonds based on their investment goals, market conditions, or changing circumstances. Whether engaging brokers for personalized assistance, relying on dealers for immediate liquidity, or leveraging electronic platforms for efficient trading, investors have various avenues to participate in the secondary market and manage their municipal bond investments effectively.
Bid Wanted versus Offerings:
In the municipal bond market, bid-wanteds and offerings represent distinct approaches to buying and selling bonds. A bid-wanted (BW) refers to a request for bids. Sellers will ‘put’ the bonds out for bid and evaluate the bids based on price or yield. At times, the seller might decide to sell at the highest bid price or not to sell the bonds at all if the feedback from the bidding community is sub-optimal. Offerings, on the other hand, refers to a seller that has predetermined the price at which they are willing to transact. Buyers can browse through available offerings and determine whether they want to purchase the bonds at the offering price. Sometimes, buyers may try to bid back or negotiate with the seller. A sophisticated market participant knows how to navigate both bid-wanted situations and determine the attractiveness of offerings. This can be accomplished by having a knowledge of the individual bonds, the current market environment, and the trading history of the security.
‘Over-the-Counter (OTC)’ Trading:
‘Over-the-Counter’ trading in municipal bonds refers to the decentralized market structure where transactions take place directly between buyers and sellers, outside of a centralized exchange. This OTC structure has implications for liquidity and transaction costs, which are important considerations for investors.
In general, the OTC market structure provides sufficient liquidity given the unique dynamics of the municipal bonds market. Investors generally have access to a broad universe of bonds available for trading through the wide network of broker-dealers and electronic trading platforms.
However, liquidity in the OTC market for municipal bonds can vary depending on factors such as the bond’s credit quality, size, and demand from investors (see Retail Domination and the Liquidity Premium). Less liquid bonds may have wider bid-ask spreads, which can increase transaction costs. Market conditions can have considerable influence on demand and during extreme volatility, accessing liquidity can be challenging.
Since individual bonds can trade infrequently and at various prices depending on the demand for the security, size, and prevailing market environment, third-party valuation services provide a reasonable estimate of fair value for portfolio reporting purposes. These third-party valuations aim to provide an objective and unbiased evaluation of the bond’s market value, taking into account factors such as credit quality, interest rates, trade history, comparable security transactions and other relevant market data. By relying on independent valuation services, investors and regulatory bodies can gain a more accurate understanding of a bond’s value, which can facilitate informed decision making, risk assessment, and regulatory compliance within the municipal bond market.
For investors and municipal market enthusiasts, being mindful of the nuances in trading these unique securities can help one build a more productive municipal bond portfolio and avoid overpaying for certain securities and/or paying suboptimal transaction costs. The market is diverse, and the sheer number of securities can feel daunting, but we hope that this post helps to unravel some of the complexities of trading this intriguing, fixed-income asset class.
Please feel free to reach out to us if you have any questions.
This content has been prepared for informational purposes only and should not be considered as investment, tax, or legal advice. We recommend all investors to consult with a financial and/or tax advisor regarding their individual circumstances before taking investment decisions.
Investing in bonds exposes the investor to the risk of loss of principal. Lower and non-rated securities are more volatile and less liquid than investment grade bonds. Liquidity risk relates to the timing of converting a security into cash without affecting the market price. Municipal bonds and preferred stocks tend to be less liquid than government or corporate bonds. Higher-yielding, longer-maturity, lower-rated, non-rated, or certain bond restrictions (minimum denomination requirements) limit or reduce the liquidity of bond holdings.
Please visit our website for a complete list of disclosures and risks: www.maustininvestments.com.