Providers of municipal bond pricing and evaluation services say they are managing to deliver accurate and transparent pricing of more than one million tax-exempt securities on a daily basis - even though the market is experiencing one of the most pronounced and prolonged periods of volatility in the last three decades.
Three of the leading pricing services -
Providers said the availability of daily trade data from the Municipal Securities Rulemaking Board has been a critical tool in being able to post accurate pricing amid intense volatility stemming from the deterioration of bond insurers and their exposure to subprime mortgage products.
Tom Doe, founder and chief executive officer of Municipal Market Advisors, a Boston-based research and strategy firm serving the fixed-income industry, said the combination of extreme volatility in the high-grade market, widening spreads, and light trading activity posed the most difficulty for evaluators at the end of 2008's second quarter.
"When you're at the end of the quarter and have thin market conditions, that provides an opportunity for a small number of transactions to move the market," Doe said. "The challenge for the evaluator is to characterize those movements as outliers or not."
He said when there are not enough transactions to provide a consistency to measure price movements on a daily basis, that adds to the challenges facing evaluation services and forces them to have to be able to recognize that "a few trades are tainting the entire market," Doe said.
"There were transactions that occurred during the last three days of June that rallied the market an additional eight basis points more than what one might have expected, and that produced an additional 1% of performance for the funds and for anyone who had a municipal position," he added. "That made it more challenging for the evaluators."
THRESHOLD FOR VARIABILITY
Investors, meanwhile, say they have noticed some minor discrepancies between provider prices and actual trade prices. However, given all the volatility the market has digested in the last several months, they say some price imbalance is to be expected and that the services are doing the best they can in a very unique and historic period.
"I think it's as challenging a time as it's ever been to price bonds given the downgrades of the insurers," said John Mousseau, vice president and portfolio manager at Cumberland Advisors in Vineland, N.J., which manages $1 billion in assets, including $650 million of tax-exempt debt.
"Your threshold for the acceptance of variability has to be much higher," he said.
Mousseau said he has seen some price discrepancies lately, but declined to distinguish which pricing services have been inaccurate at times.
"On an individual credit basis, some [bonds] are too high and some too low," he said. For instance, he pointed to a New Jersey housing bond that he traded at 98 cents on the dollar two weeks ago, but was valued at 91 cents by one of the services the same day. The bond, which was formerly insured by Financial Guaranty Insurance Co., traded on its own A-plus underlying rating.
"You're in a world where there is no trading history on bonds that lost their insurance," Mousseau explained. "As a portfolio manager, when you see these discrepancies you wonder what methodology the pricing services use in a market that has gone through this much turmoil?"
DETECT AND REFLECT
Liz Duggan, a vice president at
"Volatility is nothing new for us," she said of her firm, which is in its 40th year in business and currently prices and evaluates 1.3 million municipal bonds daily.
Duggan said with the market experiencing unprecedented volatility from the credit crunch, it is even more important to operate as timely and efficiently as possible. The company does so by constantly reviewing its evaluation processes and utilizing software models that are developed around the nuances of the municipal market.
For instance, at the end of 2007, when the monoline bond insurers began to be stripped of their triple-A status by the rating agencies and bonds started trading on their own underlying credit, the firm quickly made software alterations that systematically re-categorized some 250,000 securities that were affected, she said.
"We had to advance our approach from treating insured bonds as all one sector to treating them on their own underlying ratings," Duggan said. "We had to focus on being more efficient because the market was volatile and changing very rapidly. You only have hours to mimic what is going on the in marketplace."
Duggan cited the availability of MSRB trade data and increased communication from clients as two factors that help augment the pricing process. The company utilizes Cusip numbers, and data from traders and other market participants to substantiate the MSRB trades and deliver end-of-day prices, she said.
Interactive Data Pricing and Reference Data is also designated as a nationally recognized municipal securities information repository, and uses NRMSIR filings as part of its data.
Paul Toft, senior portfolio manager at Victory Capital Markets in Cleveland, believes that pricing providers are staying abreast of market changes amid challenging circumstances, and using the MSRB trade data helps give them a foundation for accuracy.
"We have been pretty satisfied over the last 12 months about how they have handled the volatile markets," Toft said, noting that he uses Standard & Poor's pricing information. "Occasionally there are price discrepancies, and if you disagree they are willing to discuss it, and there's an avenue to challenge something."
"While they price thousands of Cusips for us, the bonds we have aren't as challenging to price as high-yield paper," Toft added, adding that his firm only buys investment-grade bonds rated single-A or better. "I think the further down the credit curve you go, the less happy people are with the pricing services because in the high-yield area people get a little more touchy about prices."
Fred Yosca, managing director and manager of underwriting and trading at BNY Mellon Capital Markets LLC in New York City, said the credit crisis and extreme illiquidity in recent months has made evaluators' work harder than usual.
ACADEMIC GUESSES
"At times like the end of August and September of 2007, and the end of February, with the reality of the bid-side in the street, evaluations were just academic guesses," he said. "When the market goes to 115% of Treasuries, and there are no bids, pricing anything under those circumstances had to be brutal."
Under normal circumstances, evaluators use a mix of real-time MSRB data, trade information from market participants, and their own criteria to price bonds, Yosca noted. "When all those things are absent, then you're really going to struggle to find real-life trades to use in your [pricing] matrix," he said.
Frank A. Ciccotto, senior vice president at
Ciccotto said there has been no out-of-the-ordinary flow of routine price discrepancies from its core customers, such as mutual fund managers, broker-dealers, or banks.
Standard & Poor's, he said, takes a market approach to pricing bonds and uses its proprietary tools to dissect the market into categories and sub-categories, and sectors and sub-sectors. Like Interactive Data, S&P Securities Evaluations is a NRMSIR.
"We group bonds with like characteristics together and value them on their underlying ratings," Ciccotto explained. This practice, he said, has held up against market changes, such as widening credit spreads, credit quality deterioration, and weekly downgrades to bond insurers. "The changing scenario dictates how you go about pricing the bonds, but our methodology has been consistent," he said.
Moody's Evaluations Inc. said it too has been able to post accurate pricing on 1.2 million active municipal securities despite a steady but manageable amount of price discrepancies from clients, according to Mike Demas, director of evaluations.
"If a customer says it's Y and we say it's X, we talk with the customer and we always look for the transaction that can verify a price," he said. "That helps us refine what we do, and opens additional doors [of communication] for us."
MODEL-BASED APPROACH
The models for the investment-grade sector sort bonds according to criteria that is crucial to portfolio managers, traders, and investment banks, such as coupon, maturity, insurance, and use of proceeds, Demas said.
"We add or subtract basis points based on different attributes, and the evaluators monitor the marketplace and MSRB trades, and talk to trading desks and inter-dealers desks to make fine-tune price adjustments," he said. "Our software model was built to be flexible and built to handle volatility. We try to keep our models as close to the true market place as possible. We can price something down to the granularity of one Cusip number, a sector as a whole, or adjust the whole market place."
Like other providers, the company had the flexibility of its models tested earlier this year when the credit crunch worsened and some triple-A-rated insurers were no longer trading along with the rest.
"We quickly were able to build in separate credit curves just for them," Demas said.
"As the insurers separated, we were able to make adjustments to the models and still make end-of-day evaluations," said Elaine Manza, a senior evaluator at Moody's Evaluations.
"The model allowed us to flexibly identify a subset of the market and isolate it," added chief operating officer Eric Kolchinsky.
Manza said the company plans for volatility and mirrors the market's reaction as it unfolds.
"When different events happen, the municipal market is stopped dead in its tracks," she said. "When there's a new tax law, or insurance companies no longer trade the same, it takes munis a minute to wait and decide which route to take. As spreads widen, you have to keep up with it."
