The Financial Industry Regulatory Authority’s municipal market priority this year will be to ensure that brokers adequately disclose the risks associated with tax-exempt bonds backed by revenue from private and nonprofit entities, which have significantly higher default rates than general obligation bonds.
FINRA’s 2013 regulatory and examination priority report, released in January, noted that not all munis have equal security, and that brokers sometimes fail to tell customers about the risks associated with certain types of bonds.
“We are concerned that brokers may fail to disclose the material risks associated with these kinds of higher risk bonds, and that customers searching for safe-harbor investments may assume that these instruments share the same risk-versus-reward profile of general obligation municipal securities,” FINRA said in its report.
Disclosure was also the focus of FINRA’s 2012 priorities report, which called for better access by market participants to timely and accurate disclosures from issuers.
The 2013 report said general obligation bonds have historical default rates of about 0.1%, but that default rates for “sectors dependent on private profit-making or nonprofit performance” have been significantly higher.
FINRA cited a May 2012 report in which Robert Doty, a Sacramento, Calif.-based municipal advisor and president of consulting firm AGFS, said some of those bonds can default at rates hundreds or thousands of times higher than general obligation bonds.
Doty’s report, which pulled data from Municipal Market Advisors and other sources, said default rates have been as high as 16.56% for private community-development district bonds, 3.97% for nursing home bonds, 4.48% for assisted-living facility bonds, 1.62% for local multifamily housing bonds and 0.99% for economic and industrial development bonds.
Doty’s concerns were similar to those of FINRA.
“Too many investors simply believe, or are told by unknowing (or worse) sales personnel, that all municipal securities are safe and essentially are risk-free,” his report said. “That is distinctly not the case.”
He added that “naive issuers and market professionals” may rely too heavily on “expert work product” studies, which review real estate values and make financial, market and feasibility projections.
While those studies can help assess a project’s viability, Duty urged issuers and investors to investigate the researchers’ credentials, methodology and independence, and to ensure the researcher has no conflicts of interest.
Conduit bonds have also been of concern to the Securities and Exchange Commission, which recommended in its July 2012 report on the muni market that Congress remove exemptions in the Securities Act of 1933 for corporate borrowers of conduit muni bonds so that they become subject to corporate-style registration and disclosure requirements.
Congress has not yet moved forward with legislation recommended in the report.
FINRA’s priority report last year more broadly targeted disclosure, saying market participants frequently don’t have information they need to evaluate municipal securities.
“The lack of timely disclosures and complete financials often inhibit individual retail investors from making informed investment decisions, and may preclude associated persons from having a reasonable basis to recommend such a security,” FINRA said in that report.
The self regulator also reminded dealers that the Municipal Securities Rulemaking Board’s Rule G-17 on fair dealing requires them to disclose material information to customers prior to the sale of securities. Dealers should also ensure staffers can access material information on the MSRB’s EMMA system, FINRA said.
In addition, last year’s report reminded firms that suitability rules requiring them to obtain sufficient information about a security before recommending it.