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For Better Pricing & Distribution, Issuers Should Go Electronic – Part II
May 4, 2016
In my last post, I discussed the presence of Alternative Trading Systems (or ATSs) in the municipal bond market that handle the majority of trades in the secondary market. More ATSs are active today in the muni market, which is a good thing for investors because of the liquidity that they can provide. For large and frequent muni issuers, however, I think there are big opportunities to take advantage of the efficiencies and networks of electronic trading systems in the primary market, where new-issue bonds are priced and sold.
The benefits of using electronic trading platforms for debt financings fall into three buckets: better pricing, less market risk, and better investor distribution. To walk through these benefits, let’s consider how a large issuer in the muni market typically issues bonds. Large issuers like states – who may have as many bonds outstanding as a major corporation – will come to market once or twice a year and sell hundreds of millions of dollars in bonds over the course of one or two days. With a large amount of bonds being offered over such a short period, there’s a good chance that the natural investor demand in the market for a single issuer’s bonds on a single day does not perfectly match the supply of bonds being offered. When the supply of bonds exceeds the real investor demand on the day of pricing, the issuer has to sell its bonds at higher yields just to get all of the bonds sold and clear the market to complete the financing. In a lot of cases a relative value buyer is the investor who buys the bonds at the higher yields, who will then re-sell the bonds to retail investors over time at different yields than the levels at which they were originally purchased from the issuer. While for the issuer the bond pricing is complete and the funds are raised, the bonds are likely fixed at higher yields that the issuer and its taxpayers must live with over the life of the bonds. That’s not an efficient pricing process for the retail investors who end up with the bonds, and its certainly not ideal for the issuer.
With an electronic trading system, an issuer has the opportunity to offer bonds to investors very efficiently over the course of multiple days, not just a single day. A longer offering period could be structured like a rolling offering, or a shelf registration, that is commonly used in the taxable bond market by large corporate issuers in order to attract new investors to the muni market. Offering bonds over an extended period promotes better pricing for the issuer and its taxpayers because the market’s natural investor demand is not being overwhelmed by the supply of bonds being offered on a single day. Instead, bonds can be offered to investors via an electronic platform over multiple days, a selling process that allows each day’s natural investor demand for bonds to determine the supply of bonds that are actually sold. In effect, the issuer plumbs the market on a daily basis to gauge the investor demand for bonds. The issuer has better control of the pricing process, and can cut out the middle man – the relative value buyer – and instead offer bonds directly to retail investors if that’s the goal. This is better for both issuers and investors.
Market risk is another large risk that all issuers face but is difficult to hedge if the bond pricing is being executed on a single day, as it is for the typical bond sale. The risk is that on the single day that an issuer chooses to come to market, the volume of bonds being offered market-wide in the primary or secondary market overwhelms investor demand. Market risk from the secondary market is even more difficult to manage for issuers because bonds are put out for the bid by existing holders on an unscheduled basis, which could compete with the bonds being offered in the primary market. Other factors like domestic or international economic news or events can impact the U.S. Treasury market which, in turn, impacts investor demand in the muni market. A longer offering period, however, reduces the market risk that the issuer experiences, as it is effectively dollar-cost-averaging the bonds into the market by selling over multiple days or weeks. This can be done in a standard bond sale too, but it’s a lot more efficient and transparent for the issuer and investors if the sale is being managed via an electronic trading platform.
The final opportunity of using an electronic trading platform – which probably provides the biggest benefit to an issuer’s debt program over the long-term – is the ability to diversify the investor base, including the ability to connect with more retail investors. The primary market for muni bonds is really dominated by 10 or 20 very large institutional investors. These include investors with large, state-specific mutual funds. These investors are very important to issuers as they provide a lot of liquidity to the market every single day. At any point in time, though, they may have strong demand for an issuer’s bonds or they may not for various reasons, like negative fund flows, credit concerns, or the portfolio may be full on an issuer’s bonds. When their demand is weaker, the issuer’s pricing is going to suffer. Using an ATS to sell bonds can augment an issuer’s investor base to include firms that don’t typically participate in the primary market for municipal bonds. Who are these other firms that an issuer may be able to access using an open-architecture trading platform? UBS is a good example, with 7,000 brokers it is one of the biggest wealth management firms in the U.S.; LPL Financial has 14,000 brokers while Pershing has six million active accounts in the US; Ameriprise is a good candidate because it has approximately 10,000 brokers; Commonwealth Financial Network is another good example, with its $100 billion in client assets.
I witnessed first-hand the benefits of an electronic trading platform when I was in charge of the MassDirect Notes program. We offered bonds to individual investors using the trading platform TMC Bonds, and made sure the platform offered bonds to any firm representing retail investors in the country that might be interested. Our primary goal was to widen the state’s investor base because we knew better distribution would translate into better pricing, and that’s what we achieved. We were able to sell bonds to 44 different first, including those listed above, at better prices and yields than we had before, and it was a very efficient process because it was done using a trading platform.
It’s important to note that selling bonds through an alternative process like this is not for every issuer. I think it works best for large issuers with frequent borrowing needs, who can augment a traditional bond sale with one using an electronic platform to reach new investors. However, all issuers should be exploring how technology in the bond market can be used to improve their financing results and elevate their debt management programs.
In proceeding posts I will follow up on two points that we didn’t have time to cover today: first, the disclosure requirements that go along with selling bonds using an electronic trading platform. For the MassDirect Notes program, we adopted a regular schedule of disclosure releases and used our dedicated investor website to enhance our disclosure to the market. And second, the really big benefits that electronic trading platforms provide to retail investors.