Dealer intermediation and price behavior in the aftermarket for new bond issues

https://doi.org/10.1016/j.jfineco.2006.10.004Get rights and content

Abstract

Municipal bonds trade in decentralized broker-dealer markets, and are underpriced when issued, but unlike equities the average price rises slowly over several days. Newly issued municipal bonds have high levels of price dispersion and the average price rises because the mix of trade sizes changes over time. While large trades occur close to the reoffering price, small trades occur between the reoffering price to as much as 5% above the reoffering price. Using a mixed-distribution model we quantify the losses uninformed traders or issuers give up to broker-dealers.

Introduction

In his seminal paper, “A Model of Sales,” Hal Varian wrote some 25 years ago: “Economists have belatedly come to recognize that the ‘law of one price’ is no law at all. Many retail markets are instead characterized by a rather large degree of price dispersion.”

The recognition Varian refers to has arrived even more belatedly in financial economics, where through arbitrage arguments, the law of one price plays a central role in the major theoretical results of both corporate finance and asset pricing. Whether and when financial assets sell at multiple prices simultaneously is an empirical question that has received little attention.

In this paper, we study the market for newly issued municipal bonds and demonstrate that there is substantial price dispersion for these bonds: trades on one side of the market occur at radically different prices almost simultaneously. We argue that the observed price dispersion is the result of dealers’ ability to discriminate between sophisticated customers, who are informed about relative prices, or are perceived by dealers as likely to be so, and unsophisticated customers. Further, using a mixed-distribution model that separates informed and uninformed investors, we estimate the value dealers capture from uninformed buyers and find that analogous to models of costly consumer search such as Shilony (1977), Varian (1980), and Burdett and Judd (1983), some buyers appear to know which bonds are “on sale” at a given point in time, whereas others do not.

The dispersion in prices appears to be sustainable because of the institutional mechanisms through which the bonds are issued, and the decentralized, opaque market setting in which the bonds are traded. This environment imposes search costs on small investors who trade infrequently. These search costs may be associated with identifying and switching to dealers offering better terms as in Shilony (1977), with consulting public sources of information as in Varian (1980), or with obtaining multiple price quotations as in Burdett and Judd (1983). In the market for municipal bonds, however, information about pricing is relatively easy to obtain for those who “know where to look.” The search costs may therefore be best understood as the investment of time and effort needed to educate oneself about these sources of information. That is, it may be costly to become a “sophisticated shopper” for municipal bonds.

The municipal bond market is a classic decentralized broker-dealer market. Pricing information is costly to obtain, and until recently transactions prices have not been recorded in a central source. While other over-the-counter markets, such as corporate and treasury bonds, are dominated by institutional investors trading in large quantities, the tax-exempt status of municipals makes them attractive to individual, retail investors. Thus, as in equity markets, large institutional traders and small investors coexist in the municipal market. However, unlike in equity markets, there is no pre-trade transparency. Post-trade transparency was also limited in our sample period; recently post-trade transparency has increased and currently investors can observe transactions prices on-line at close to real time.

The transactions data in our sample were collected by the Municipal Securities Rule Making Board (MSRB) as a first step in their efforts to create a more transparent venue for trading. These data record all transactions by registered broker-dealers, but were only made available to the public with a lag. Transactions are identified as sales by dealers to customers, purchases by dealers from customers, and interdealer trades. We match these transactions data with information on new issues hand-collected from prospectuses and provided to us by Primuni.com. Our data include 190,300 trades in 12,493 new bonds issued in 1,000 deals from February 2000 through July 2003.

We document substantial underpricing for new issues, particularly those targeted for the retail market. In the equity markets, the most underpriced issues are also likely to be the most oversubscribed, so that the underwriters themselves do not benefit directly from the underpricing. In the municipal market in contrast, bonds are likely to be taken into inventory or to be sold to other dealers in the underwriting syndicate at or below the reoffering price,1 so that the underwriter-dealers do benefit directly from underpricing. Moreover, the underpricing only emerges gradually. Thus, an issuer who simply compares the reoffering price on the bond to average transactions prices on the first day of trading would underestimate both the extent of underpricing and the profits to the underwriters.

While average prices increase steadily in the days following the start of trading in new issues, the price increase does not appear to be the result of gradual price discovery or the release of information. The prices at which dealers trade with each other and the prices at which dealers purchase bonds from customers do not drift upward. Instead, a large proportion of customers buy the bonds at the reoffering price, while others purchase at a wide range of prices that can be much higher than the reoffering price.

Prices at which customers buy have a bimodal distribution in the early days of a bond's life. The price dispersion does not coincide directly with dispersion in proxies for the customer's type. For a variety of reasons we might expect trading costs to be lower for large buyers. For instance, there are surely fixed costs associated with processing trades and identifying counterparties. Large institutional traders are also likely to be more continuously engaged in the market, increasing their access to pricing information, and to have repeated interactions with broker-dealers, increasing their bargaining power with them. We might expect, then, that large traders obtain good prices while small traders do not.

We find, however, that while large purchases occur at lower and less variable prices, many small purchases also occur on very attractive terms whereas others do not. A natural explanation for this observation is that small buyers differ widely in terms of how well informed they are about the bonds they are buying. Some small buyers know the bonds have been recently issued and they know the reoffering yield, which serves as a natural focal point in negotiating with broker-dealers. Others do not. Larger traders, in contrast, are more homogeneously informed. As time passes from the start of trading, information about a particular issue is more costly to obtain or less widely available, and the mix of informed and uninformed traders changes, leading to predictable rises in average prices.

We document the price behavior descriptively by stratifying the sample by trade size and days from the start of trading and studying the extent of price dispersion. The price dispersion is economically significant. For bonds with high levels of retail participation, prices vary by 5% or more, which is roughly the annual yield on a municipal bond during the sample period.

We also estimate a mixed-distribution model that treats trades as drawn from two distributions, one for informed buyers and the other for uninformed buyers. A latent variable for the cost of becoming informed about pricing determines the distribution from which an observation is drawn. Using the estimated parameters from the model, we calculate the “money left on the table” by buyers where money left on the table is a measure of the surplus accruing to broker-dealers that buyers could have captured by becoming informed. To the extent the money left on the table accrues to the broker-dealers rather than the issuers, it is also a measure of the surplus that issuers could have captured by obtaining direct access to the ultimate buyers. On average, the money left on the table amounts to a quarter of the profits that underwriter-dealers earn on an issue.

If trading is costly for individual investors, or if it is costly for them to acquire the institutional sophistication that would allow them to trade on better terms, then we would expect intermediaries to offer them information indirectly through delegated portfolio management. Mutual funds are one way for individuals to trade on institutional terms, but at the cost of fees and loss of direct control over their portfolio. Our estimates of the costs of trading to individuals suggest they value direct control.

Some delegation mechanisms may involve fees that are not directly observable in our data which would lead us to overstate the apparent sophistication of some small traders and understate the costs of trading for them. Examples are so-called managed accounts with annual wrap fees that are a percentage of assets under management, and agency trades that involve a commission not reported in our data.

To evaluate the importance of such effects, we exclude or consolidate transactions that are likely to be agency or managed-account trades. We also include proxies for trades that are likely to be managed account trades in our mixed-distribution model. The robust nature of our findings suggests many retail investors obtain attractive terms of trade directly, which is not surprising given the wide availability of information about upcoming municipal bond issues. Moreover, both wrap fees and commissions on agency trades are small relative to the dispersion we observe in the prices retail investors pay. This is what we would expect if intermediaries compete more aggressively on dimensions that are transparent to investors. Competitive forces should limit relatively transparent sources of cost to investors, such as commissions or wrap fees.

The behavior of prices for newly issued municipals, which trade over the counter, stands in marked contrast to the behavior of prices for public offerings of equity, which trade on organized exchanges. In initial public offerings (IPOs) there is a great deal of uncertainty about the value of the underlying assets. Thus while both retail and institutional investors are active in the aftermarket for equities, as with municipals, price adjustment in IPOs takes place almost immediately in the secondary market, with subsequent price movements largely unpredictable over short horizons.

Note that the sources of underpricing are not fully understood. For IPOs, the equity issuance process makes the underpricing transparent to everyone involved, as the first transaction on the exchange gives issuers a good measure of how much their shares have been underpriced. The puzzle is why, given market transparency, competition among underwriters and self-interested behavior by issuers does not reduce the underpricing. In the municipal market, on the other hand, there is no single “market price” by which to measure the costs to issuers or uninformed investors. Rather, there are market prices.

The price dispersion also creates complications for the tax authority. The tax code limits the returns issuers can earn on municipal bond proceeds to preclude tax-arbitrage strategies. These limitations are stated in terms of the “issue price” of the bonds. The bond counsel typically relies on a certificate from the underwriters to establish the issue price of the bonds. In practice this price is generally the reoffering price agreed upon by the issuer and underwriter and disseminated to the investing community via The Bond Buyer and Bloomberg news services.2 In our sample, large portions of many issues are not sold at the reoffering yield, and in a substantial fraction of the issues none of the bonds are sold with yields at or above the reoffering yield.

Several recent papers show that the costs of trade for retail investors in over-the-counter bond markets can be very high, and that these costs are related to the degree of transparency in the market place. Harris and Piwowar (2006) use time-series methods to estimate trading costs for municipal bonds and show that the costs are decreasing in trade size. Green, Hollifield, Schürhoff (2007) match purchases and sales in seasoned bonds to estimate the profits to dealers from liquidity provision. Their structural model yields estimates of relative bargaining power for customers and dealers that depend on trade size. Biais and Green (2005) compare trading costs in the current environment to costs during historical periods when bonds were actively traded on exchanges. Bessembinder, Maxwell, and Venkataraman (2007), Edwards, Harris, and Piwowar (2007) and Goldstein, Hotchkiss, and Sirri (2007) study the costs of trade in corporate bonds and show that increased post-trade transparency lowers trading costs.

All of these studies are informative about the effects of the relative lack of price transparency on liquidity. The nature and direction of causality is difficult to assess, however. The trading venue, costs of trade, and frequency of trade are themselves jointly endogenous outcomes. Perhaps the bonds trade in decentralized, opaque markets in part because investors rarely need or want to trade them, and the costs are high because it is extremely difficult for intermediaries to identify and match counterparties. The transactions we study take place in a setting with an exogenous need for a relatively high volume of trade: The newly issued bonds must be moved through the inventories of intermediating dealers to final investors. However, even though considerable trade occurs, we still see small investors trading on radically different terms than large investors, and on radically different terms from each other, at virtually the same instant in time. If price information were more transparent, especially pre-trade price information, it seems unlikely this could occur.

The municipal market is also a particularly appropriate venue in which to study the impact of transparency on terms of trade because individual retail investors are a natural clientele for the bonds. Tax considerations make corporate and government bonds relatively unattractive to hold directly. Accordingly, they tend to be held to in tax-deferred accounts that are intermediated. If it proves costly for individuals to trade in the corporate market, it is unclear that this is in any way costly. In the municipal market, 39% of outstanding bonds are held directly by households,3 and if it is costly for them to trade these holdings there is surely some associated welfare loss.

In Section 2 we describe the process through which municipal bonds are issued and our sample of new bonds and trades. Section 3 analyzes the evolution and dispersion of prices over time and also that many offerings fail to meet the IRS requirement that 10% of the bonds be sold at the reoffering yield. In Section 4 we estimate a mixed-distribution model of the determinants of the markup over the reoffering price for informed and naïve investors. Section 5 concludes by discussing the policy issues related to our research. The Appendix describes our sample construction.

Section snippets

Municipal bond issuance and the sample

The primary market for municipal bonds is large both in terms of value and number of offerings. For instance, the value of new issues was $458 billion in 2005, having risen steadily from roughly $60 billion per year in the early 1980s.4 Further, the municipal market is competitive in that the number of issuers is large and the size of each issue is small in comparison to the corporate market. Municipal bonds are issued

The evolution of prices over time

Fig. 1 illustrates the histories of sales to customers for eight individual bonds from our sample. These bonds, which include both actively and less actively traded bonds, cover a range of typical behaviors. In each plot the horizontal axis is the number of days since the initiation of trade, and the vertical axis is the difference between the transaction price and the reoffering price, measured as a percentage of the reoffering price. We refer to this percentage as the markup the dealer earns

A mixed-distribution model

The behavior evident in Fig. 3 suggests that dealer markups are drawn from two distributions. Some investors trade at or close to the reoffering price, while at the same time other investors are buying bonds at a diffuse set of prices that can be very far from the reoffering price. From Fig. 4 and Table 6 it is apparent that large buyers are more homogeneous in the terms of trade they receive, suggesting they are more consistently informed.

We report estimates from a mixed-distribution model for

Conclusions

The behavior of prices for newly issued securities are informative about the role of financial intermediaries in the security issuance process, the situations in which they can exercise market power, the nature of the costs they face, and the efficiency with which capital is provided to those who demand it.

In contrast to trading venues such as equity markets with more transparency, the market for municipal bonds exhibits high levels of price dispersion, even within trade-size categories.

References (12)

  • Y. Shilony

    Mixed pricing in oligopoly

    Journal of Economic Theory

    (1977)
  • Ballard, F.L., 2006. ABCs of Tax Arbitrage: Tax Rules for Investment of Bond Proceeds by Municipalities. American Bar...
  • Bessembinder, H., Maxwell, W.F., Venkataraman, K., 2007. Market transparency, liquidity externalities and institutional...
  • Biais, B., Green, R.C., 2005. The micro-structure of the bond market in the 20th century. Working paper. Carnegie...
  • K. Burdett et al.

    Equilibrium price dispersion

    Econometrica

    (1983)
  • A.K. Edwards et al.

    Corporate bond market transparency and transactions costs

    Journal of Finance

    (2007)
There are more references available in the full text version of this article.

Cited by (146)

  • Dealer networks, client sophistication and pricing in OTC derivatives

    2024, Journal of International Money and Finance
  • Retail bond investors and credit ratings

    2023, Journal of Accounting and Economics
  • Disclosure-based regulation and municipal security trade prices

    2024, Journal of Financial Economic Policy
View all citing articles on Scopus

We thank Sara Buss, Tal Heppenstall, Roger Hayes, Chris Fama, and John Roll for educating us about the structure of the muni market, and PriMuni LLC for providing the data set. We also thank Shane Corwin, Espen Eckbo, Ron Goettler, Jean Helwege, Roni Michaely, Michael Piwowar, Enrique Schroth, and audiences at a number of seminars and conferences for helpful comments. We especially appreciate the efforts of an anonymous referee, whose comments improved the paper on several dimensions.

View full text