In the municipal bond market, bigger has become better.
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"Aggressive demand for larger blocks has resulted in a bifurcated market in the 10-year plus area of the curve with the larger, more liquid bonds receiving more aggressive bids than smaller size issues," Peter DeGroot, a municipal bond strategist at Lehman Brothers, wrote in an August report. The trend is largely due to the growing dominance of institutions and arbitrage buyers, he said.
"There are probably three to five basis points between $1 million bond blocks and $10 million bond blocks," said Barney Dibenedetto, manager of the municipal evaluation desk at Standard & Poor's in New York. "It has been a little while now -- probably over the last six months to a year."
Prices paid per bond for large blocks in desirable sectors and maturities are up and yields are down relative to the same bonds sold in smaller blocks because the number of big blocks is limited.
"If you have a block of $10 million, you are going to get a higher price for it than if you have a block of $1.5 million or $2.5 million, because if you have a block of $2.5 million, the arbs don't want it," Reid Smith, a principal and senior portfolio manager at the Vanguard Group Inc. in Valley Forge, Pa. "The small blocks are cheaper because they are being overlooked by the large players."
Institutions and arbitrage buyers are the most active players in the 10-year to 30-year range and usually like to purchase blocks at a minimum of $10 million. On the other hand, retail buyers and high-net-worth individuals are less frequent shoppers for those maturities and typically buy in $1 million sized blocks or smaller because otherwise they would not have sufficient capital to maintain a diverse portfolio of bonds.
As a result, some municipal bond strategists think the muni bond market has recently behaved in newfound ways.
The presence of "new era buyers" such as proprietary desks, tender option bond programs, hedge funds, and crossover accounts means there are now faster-responding supporting bids when the municipal market gets weaker, said Tom Doe, president of the Concord, Mass.-based Municipal Market Advisors, which compiles the Consensus Yield Curve.
"In the February to March sell-off, when prices declined, the sell-off was not as great in the longer maturities like we would have normally seen over the last five years, and that certainly told me that there was a very different presence in the market now," Doe said.
These buyers typically take a particular position in a security category that will enhance the performance of their portfolio, DeGroot said. "To get to the economies that they need to fulfill their strategies, they are buying big blocks and they are ignoring small blocks ... They are not going to waste their time buying 10 $1 million bond blocks or five $2 million blocks," he added. "Instead, they just go out and execute a trade for one $10 million block or for that matter one $20 million bond block."
Institutions and arbitrage buyers often need to purchase hundreds of millions of dollars worth of bonds from a specific sector or maturity in a very short amount of time in order to reposition the concentrations within their large portfolios.
"If a block of bonds is only $2.5 million, it is difficult for me to do what I need to do in terms of market posture, strategy, and sectors," Vanguard's Smith said regarding the management of his municipal bond mutual funds. "In order to execute that within a relatively rapid period of time, I have to move larger blocks and the arbs are doing that too."
Another reason large blocks of bonds tend to outperform smaller blocks in the secondary market is because they are easy to dispose of if necessary, said DeGroot.
"If you have a big block of bonds, you get a better bid because a big block of bonds means you have greater liquidity," Smith said. Those investors that need to move in and out of certain bonds over a relative short period of time are willing to pay a premium for that, he added.
Conversely, astute investors who do not require a substantial amount of liquidity have opportunities to find value in smaller blocks of bonds that are being ignored by the larger investors, Smith said.
Despite the different prices available to muni investors, the main bond pricing services put their focus on the prices paid by institutional buyers.
All quotes offered by Standard & Poor's pricing service are designed to reflect the price level for a $1 million block, although they take into consideration trades for larger blocks, according to Dibenedetto.
FT Interactive Data typically starts with blocks worth $1 million because its evaluations are usually tailored to show what an institutional buyer would pay in the marketplace for a current sale of a block of that size or more, said Liz Duggan, a senior director at the company. Municipal Market Data begins tracking prices offered for $2 million blocks and extends to those offered for larger sized blocks, according to Brian Bellucci, a managing analyst at the Boston-based firm.
MMA surveys a broad range of market participants including both large and small buyers to derive its Consensus curve, according to Doe.
"We do have firms that do more retail than institutional business, and we do have some smaller institutional accounts that may be trading in smaller blocks than, say, a large arbitrage account on a proprietary desk," he said. "We also have mutual funds with separate accounts, money managers, we have some arb accounts, we have property and casualty companies -- so we have a wide variety of types that represent the levels we get to construct our index."
Of MMD, MMA, Standard & Poor's, and FT Interactive Data, none have changed their parameters in response to the recent pricing trends.
In the 1970s, the Municipal Securities Rulemaking Board established Rule G-30, which requires that prices charged by a municipal securities dealer be "fair and reasonable, taking into consideration all relevant factors," including their right to make a profit, the availability of the security in the market, its price or yield, and their best judgement of its fair value.
"The MSRB has accepted market variation on prices due to block sizes since it adopted the G-30," said Christopher Taylor, executive director at the MSRB in Alexandria, Va. "Whether or not a retail or institutional buyer buys a block of bonds at a fair price depends entirely on the levels the bonds were selling at on that day."
Sarah Bohn, a spokeswoman for the NASD, which serves as the primary private-sector regulator of the securities laws drafted by the MSRB, declined to comment on the possibility of any inquiries into the recent price differentials. (c) 2005 The Bond Buyer and SourceMedia, Inc. All rights reserved. http://www.bondbuyer.com http://www.sourcemedia.com
