The prior article A Technology Solution For Muni Bond Disclosure discussed how new technologies and data science methods are transforming disclosure in the municipal bond market.
This article, the sixth and final piece of a six-part series on investor disclosure in the municipal bond market, outlines how municipalities and authorities pay the very high real dollar cost of inefficient disclosure. Ironically, it is these very borrowers who use this capital market that are the one’s with the power to correct many of the market’s disclosure problems.
The Cost of Disclosure
Understandably, municipal bond borrowers want the best, lowest interest rates for their bonds. There is grumbling that, for all this talk of disclosure, they don’t see it in the underwriting price of their bonds. But to expect efficient pricing when disclosure is reported months late, lacks consistently applied standards and is not structured data? It’s like having frosted windows installed and then being upset the view isn’t clear.
It’s About Time—and Time is Money.
In the United States, the Securities and Exchange Commission established rules for publicly traded companies with more than $75 million and less than $700 million in “public float” to report annual results, a 10-K, within 75 days of fiscal year end. Companies with public float above $700 million have 60 days. Quarterly reporting, filing a 10Q, has a deadline of 40 days.
And the deadlines set for financial filings for municipal bond issuers? “When and if available.” It’s in SEC Rule 15c2-12, Section 240.15c2-12 (b)(5)(i)(B). Again, for the intrepid reader willing to dig, follow the link to the section.
What does “when and if available” translate to in the real world? To answer that question, the folks at Merritt Research have been assiduously tracking the reporting-date data on some 10,700 borrowers since 2007. Their numbers quantify a discouraging statistic: for the average municipality, an audit is released nearly a full six months after the close of the fiscal year. For the average borrower with a June 30 fiscal year end, the report may not even come out in the same calendar year as the fiscal year being reported on.
That’s the average. Some reporting runs out seven or eight months. The later the release, the staler the numbers. If timeliness is transparency, it is no wonder the municipal bond market is so often tagged as being opaque.
The Regulator Be Your Guide
It’s not as if there is no regulatory timing guidance as to disclosure for the municipal bond market. Under the Continuing Disclosure Agreements mandated by the Municipal Securities Rulemaking Board (MSRB), borrowers must enter into with the underwriters of their bonds, an annual filing to the MSRB’s Electronic Municipal Market Access (EMMA) central filing repository is required. There are penalties if it is missed. Corporates have between 60 to 75 days from the fiscal year end. Municipals have 364 days.
Some municipal reporting requirements are not so lax. If a “material event” occurs—there are now 16 defined material event disclosures codified in the rule—a borrower is required to post notification on EMMA within ten days.
One cannot miss the irony here. A loose interpretation suggests that the Comprehensive Annual Financial Report (CAFR), arguably the most important financial document produced by a municipality, filled with a year’s worth of truly material events, has 364 days to be posted. Yet, if something goes wrong that is material to those financials, that has to be reported immediately. The cart is ahead by ten days. The horse will follow. When and if it is available.
The inability to produce the relevant and timely financial and operating reports in a format and structure that regulators, borrowers and investors all so eagerly want has expensive implications.
The most expensive are quantified in the rates borrowers pay to access the market. Any number of factors go into interest rates a borrower pays. For example, there are yields on U.S. Treasury bonds, the AAA municipal bond yield curve, and the creditworthiness of the borrower.
Another key component is a liquidity premium. The rationale behind the liquidity premium is along these lines. If investors think the bonds they are looking to buy won’t trade well in the market, the interest rates they are going to ask for those bonds are going to be higher than a bond that does trade well.
That difference between the two bonds is the liquidity premium.
Some may scoff at such thinking by investors. After all, the majority of municipal bonds don’t trade. They end up “going into the vault,” as it is called in the business. Why should a borrower care, or worse, be penalized by investors, if their bond isn’t likely to trade anyway?
The answer is in valuation—the pricing of the bonds. Bonds in any portfolio, be it a separately managed account, a mutual fund or a bank trust department, get priced daily so an investor knows what their portfolio is worth on any given day. The prices affixed to those bonds are determined many ways, but high up on the list in bond pricing determinants are trades in either the exact bond or similar bonds.
Here’s where disclosure makes a dollar-defined difference. In order to set a price on a bond that doesn’t trade, an evaluator at a pricing service compares it to a bond that does trade. The next step is to compare creditworthiness of the two bonds. Relying on a credit rating by a rating agency such as Standard & Poor’s or Moody’s has risks. While those rating services strive to maintain ratings up to the minute to the financial and economic situation of a borrower, they simply can’t do that for over 50,000 municipal bond market borrowers.
For evaluators and investors to be able to have more current information to determine creditworthiness, there has to be regular disclosure from the borrower. A bond that doesn’t trade and has poor disclosure gets penalized. The valuation—the price on that bond—is going to be lower, which means the interest rate is going to be higher. (Keep in mind that for fixed income securities, the dollar price of a bond is the inverse of its market interest rate). Investors know this and quantify it into a higher liquidity premium. It’s a bit of a self-fulfilling prophecy.
For the borrower, a liquidity premium of even a few basis points (a basis point is 1/100th of 1%, or .001) can be very costly. A $50 million municipal bond issue with a 5-basis point liquidity premium will cost the borrower some $7.5 million dollars over the term of bond with a 30-year maturity. That’s an expensive price to carry for inadequate disclosure.
The Global Municipal Bond Market
The lack of consistent disclosure standards and metrics hurts borrowers in other ways. There is increasing global interest in taxable municipal bonds. Taxable municipal bonds are issued by borrowers for projects that would not otherwise qualify for tax exempt status under the stringent use-of-proceeds rules set forth under Internal Revenue Service Code. The interest paid on these bonds is taxable to the investor. While the taxable rate is higher than on tax exempt bonds, the offset of being able to use the proceeds unencumbered by IRS rules more than offsets that.
Taxable municipal bonds are increasingly popular with international investors, sovereign funds, banks, and pensions. For these large institutional non-domestic investors, the bonds offer asset diversification in their portfolios, maturities of 30 years or longer (not often found in the corporate bond market), and relatively stable credit profiles.
Demand for taxable municipal bonds is growing and borrowers are increasingly turning to these debt instruments to borrow. The Securities and Financial Markets Association (SIFMA) tracks the growth in issuance in this asset class. For years, taxable municipal bond issuance hovered around $30 billion annually. But recently, that has grown dramatically. In 2019, there were $67.3 billion in taxable municipal bonds issues. Year to date 2020 (August), the number is already over $81.3 billion.
While being able to access markets other than domestic is good news for municipal bond borrowers, international institutional investors are used to disclosure frameworks that are digital and have well-defined standards, deadlines, and taxonomies. There is low tolerance for the lax, vague disclosure rules governing the municipal bond market. Like domestic investors in tax exempt bonds, the international investor imposes a higher rate to account for the risk of holding taxable bonds in their portfolio whose creditworthiness cannot be easily tracked and the prices of which may be poorly valued.
“If municipal bonds are to compete in the global fixed income market, municipal borrowers will face increased pressure to conform to superior disclosure standards practiced by corporations” asserts Gerald Lian, Esq., a municipal bond credit analyst with more than 30 years of experience and an Adjunct Professor at NYU Wagner Graduate School of Public Finance.
Former Harvard University President Derek Bok observed “If you think education is expensive, try ignorance.” A variation of this for the muni market might be, if you think disclosure is expensive, try not disclosing.
The municipal bond market’s failure establish clear, uniform disclosure standards and metrics and integrate those into current technologies costs municipal borrowers—and the tax paying American public—billions every year. With proven solutions readily available, excuses not to expeditiously implement those ring hollow. The market needs implementation, not further examination.
Optimistically, the municipal bond market will embrace these solutions and dispel the dated and cumbersome methods instituted decades ago. The other capital markets of the 21st century function more effectively and efficiently with these taxonomies and technologies.
It would be great to see the municipal bond market join that 21st century.
Before it’s over.
Read the other parts of the series: