As the Securities and Exchange Commission and other municipal bond industry organizations look to improve disclosure in the muni market, one small company is making strides with a step in this process — intraday bond pricing. Andrew Kalotay & Associates began work on a program to do this after an new client approached them in December of last year. Van Eck Global Securities was interested in creating a municipal bond exchange-traded fund and needed pricing throughout the day to do this. After months and many meetings, Interactive Data Corp. and the SEC have put the program in motion. It started running live in September, but there are still some flaws that need to be hammered out.“The difficulty today is that there is no live benchmark for municipal bonds,” said Andrew Kalotay, president of the company. “So we look at historical relationships between the muni yield curve and the end-of-day pricing of Interactive Data, and then we look at price movements throughout the day of the London Interbank Offered Rate swap curve.”Throughout the day, Kalotay’s software takes Interactive Data’s end-of-day price the prior trading session and then prices thousands of bonds every 15 seconds based on Libor movement. The data is simultaneously sent to Interactive Data and is packaged into baskets for municipal bond ETFs. All four companies offering ETFs — Van Eck, State Street Global Advisors, Powershares Capital Management LLC, and Barclays Global Investors — use the same software and Interactive Data’s programs in pricing their ETFs.“It is pretty revolutionary for the municipal market and the feedback to date has been very positive,” said Liz Duggan, vice president at Interactive Data. “It is a new concept out there and the service is expanding in the number of funds, the ETF sponsors, and we are going outside munis into using the service for Treasury bonds, corporate bonds, and preferred securities.”Historical data provided by Kalotay shows a very close correlation with Interactive Data’s end-of-day pricing. As he explained, the only way to back-test his software was by comparing their own end-of-day theoretical pricing to that of Interactive Data’s end-of-day price back in time. In 2006, tracking 10,875 different securities, the percentage of difference between Kalotay’s and Interactive Data’s end price was an average difference of $0.0022. Standard deviation was $0.1217. Over 90% of all prices inputted were within 0.10% of the price Interactive Data submitted.From January to August of 2007, the results are similar, but a little further off. In tracking the prices of 16,000 bonds, the average price difference was $0.0022, but the standard deviation grew to $0.2342. This was because of market conditions in August.Market volatility since beginning in August has exposed one flaw in the system. The pricing service is based throughout the day on a taxable curve. In August, November, and parts of December, the municipal bond market deviated from the taxable markets.“The muni market has moved in other directions from Libor,” Kalotay said. “Obviously, our software does not know this, so our program takes the taxable curve and comes up with a surrogate tax-exempt curve, and in some cases we end up with prices that are not accurate.”Thus, in the 2007 data, there are outliers that did not exist in 2006 that affected the standard deviation of the back-testing.To address this problem, Kalotay has been meeting with Municipal Market Advisors to “add color to our system,” as Kalotay puts it.In meetings over recent weeks with MMA, a company that provides market analysis and investment strategies, the two have found a way to work together.Tom Doe, president of MMA, sees Kalotay’s software as an excellent way to provide more transparent and accurate data to the ever-growing derivative segment of the muni market, and in turn, Kalotay is looking for intraday, muni-specific data that Doe’s company provides.“We’ll provide the spreads on the pricing of deal in the primary, provide flows in the marketplace throughout the day where there is heavy selling and where there is strength or not, and how that impacts the curve,” Doe said. “He has an incredible technology, or quantitative power, that allows him to do creative things and using our information will allow him to portray the changes in the muni market throughout the day.”In turn, Doe sees the benefit of a better live muni yield curve for the municipal derivatives market. He noted that in producing an options-free yield curve, as options are used heavily on the taxable side and distort a translation to the tax-exempt side, many big institutions doing business in the rate-lock market will benefit dramatically.“We’ve had conversations with some major dealers in the rate-lock market and during the market turbulence this fall, there were some problems with settlements because the prices were all over the place using traditional methods of providing a rate-lock, so with Kalotay’s data we can really create a premium, 5% coupon yield curve that is more accurate.”In a rate-lock agreement, a fund will sign a contract with another party — typically an established bank — that agrees to a future yield level on a certain maturity in a given amount of time. Once the time has elapsed, the contract must be settled, with one party paying the difference of actual yields at that time and what the agreed upon rate lock was. Thomson Financial’s Municipal Market Data yield curves and Lehman Brothers Municipal Index Swap curve are currently used for this.While these new developments are under way, users of the service appear to be satisfied in the meantime.“I’ve been very pleased with how everything on the ETF side of things has gone from the standpoint of the intraday price, the bid/ask spreads, and how we’ve been fairly tight form the standpoint of premiums and discounts,” said Tim Ryan, who manages State Street’s municipal bond ETFs. “Even during a very challenging time that we’ve been faced with, things are functioning fine. The pricing services are in a state of transition right now and we are entering a brave new world, but our products are trading efficiently.”Ryan also noted that State Street’s national muni bond ETF, ticker symbol TFI, has grown since its inception. It was seeded with $22 million and now has roughly $70 million of assets. It also has the highest three-month average of daily trading volume with 47,196 shares. Duggan also noted that interest in the intraday pricing has sparked abroad, as several European companies are in discussion with Interactive Data to use the system. When asked how and when Kalotay would be able to include MMA information and become less dependent on Libor, Kalotaysaid he would have a better idea next month.
