Don’t Look Now, but the Muni Industry Is Changing
Around this time of the year, it’s always tempting to take a couple steps back and try to see what the market has in store for us going forward. By virtue of not being associated with either a major broker-dealer or a major asset manager, we’ve been fortunate enough to have interacted this year with an astonishing array of tech entrepreneurs and market veterans, many with pioneering visions on how to improve the municipal bond market. The good news: change is coming to the tax-exempt sector.
Why now? In our view, the potential catalysts for change include: (1) the end of the great bull market in bonds; (2) the new regulatory environment under Dodd-Frank; and (3) advances in information and trading technology.
We expect technology to drive two major themes in the new year: “access to information” and “access to liquidity.”
Of course, markets don’t change overnight. They evolve over a number of years, if not decades. However, 2014 may turn out to be the year where many of the recent developments in the tax-exempt market converge in a dramatic way. This could be the year the muni market finally sheds its “stodgy” label.
First, some perspective: the great bull market that took interest rates to record lows has been a rising tide that lifts all boats. It has also masked a multitude of investment sins. With the first whiff of a bear market in bonds, all of that changed this year. The massive outflows from the muni funds, $58 billion so far this year, has changed the dynamics of the industry. Some of the fund redemptions have reportedly gone into direct bond purchases and managed accounts, leading to a renewed industry focus on the “retail” buyer.
Regulatory pressures will also force the industry to change, particularly with regard to protecting the individual investor. Naturally, the best protection you can give a retail buyer against excessive retail markups is access to a price discovery tool that allows them to assess what a “fair” price should be.
As usual, technology will be the enabler of change. No, we’re not talking about having a drone drop off the next 400-page Preliminary Official Statement at your front door. We’re talking about the dramatic decline in the cost of computing power and processing speed that will finally allow complex programs to build much more comprehensive data bases and replicate some aspects of the investment process.
We expect technology to drive two major themes in the new year: “access to information” and “access to liquidity.”
Under the “access to information” heading, we can group all ongoing efforts to improve price discovery and transparency, as well as municipal disclosure. There is no doubt that the Municipal Securities Rulemaking Board (MSRB) has substantially improved the information flow with its EMMA site. The trading data and disclosure items posted to EMMA have greatly contributed to transparency efforts, although the sheer amount of information could sometimes be overwhelming. The next logical step would be to turn EMMA into the ultimate muni information hub, drawing upon the resources of all the various data vendors now servicing the industry. We do note one component that has been conspicuously absent from EMMA as well as most muni-centric web sites: credit research, something which seems inconsistent with current regulatory efforts to wean investors from Big Three agency ratings. Leading data providers such as Merritt Research Services and our column’s host, MuniNetGuide, have told us they intend to be on the cutting edge of this new information wave.
Looking back, 2013 may well be viewed as the year social media finally made their mark on the muni scene.
Muni disclosure efforts should also take a huge leap forward starting in 2014, as new techniques for extracting data from municipal disclosure documents in pdf format come to the fore. Although many mechanical hurdles remain to be overcome, eventual adoption of technology such as XBRL should foster the development of muni financial data bases and, by extension, muni credit scoring models.
Looking back, 2013 may well be viewed as the year social media finally made their mark on the muni scene. Muni-oriented blogs are now fairly commonplace, offering a wide variety of opinions, some supportable, some not as much. Investment discussion groups are springing up all over LinkedIn, including Axios’ own Municipal Credit Research Forum, whose membership now numbers close to 700.
Nowhere has the impact been more dramatic than on Twitter, which has become a key clearinghouse of information on municipal finance. For instance, when the City of Detroit held its bankruptcy eligibility hearing a couple of weeks ago, one could have followed the entire proceedings in real-time through tweets posted by the Detroit Free Press. And the speed of information dissemination has accelerated to match: the latest economic indicators from Puerto Rico hit Twitter more than threee hours before they were reported in the financial media. Every “new” medium has its stars and one of the most prolific contributors is without a doubt Cate Long of Muniland fame: you may not always agree with her but you know she cares about the quality of the information she posts online.
So far, no muni Twitter post has had a market-moving impact, but that remains to be seen. One obvious caveat: as is the case with any other communication medium, the raw information one can obtain from Twitter and other online sources should never be taken at face value, as opinion usually comes disguised as fact.
Although muni traders are notoriously reactive in nature, technology may allow them to be more pro-active in seeking out opportunities. Crossover investors in particular could benefit from new software designed to scour all news events reported across the internet for credit-significant events (e.g. Bitvore). Others could use an early warning system based on disclosure data to identify potential defaults (e.g. FactEntry). Of course, the relative illiquidity of the muni market will limit whether or not one could actually execute on such ideas.
As we mentioned earlier, “access to liquidity” is the other main theme for 2014. The ongoing liquidity crisis in the fixed-income sector has been well-documented and hotly debated this year. The dramatic decline in dealer inventories since 2008, incorporates as well as in municipals, does not portend well for liquidity going forward. It will certainly be exacerbated by the recently-passed Volcker Rule which, among other things, took out a key financing mechanism for dealer desks: the so-called tender option bond program. If the violence of the muni selloff this past summer is any indication, we’re in for more volatility going forward.
Out of sheer necessity, fixed-income participants are exploring ways to create direct liquidity pools among themselves and reduce their reliance on the broker-dealer community. Large institutional complexes such as Black Rock have been experimenting with so-called “matching platforms”, electronic trading systems designed to match buyers directly with sellers, although such efforts have so far been confined to corporates.
On the muni side, many electronic trading systems are geared toward meeting the needs of direct retail buyers and their proxies, Registered Investment Advisors (RIAs) and Separately Managed Account (SMA) managers. MuniAxis, for instance, appears focused on tightening up the bid-wanted process for retail investors, potentially reducing their transaction costs. TradeWeb’s recent acquisition of BondDesk holds the tantalizing promise of making institutional quality trading technology available to middle market investors. Some of the largest SMA managers in the business are also considering building direct matching platforms among themselves to create additional liquidity. One common thread running through all these efforts: how to reduce transaction costs for retail-sized blocks.
“Liquidity” and “information” often go hand-in-hand. The eventual success of many of the electronic platforms will hinge on their ability to supply traders with price discovery tools that allow them to make informed investment decisions. The traditional muni information model goes something like this: (1) broker contacts potential buyer with bond offering; (2) buyer asks what the bonds may be “worth"; and (3) broker supplies third party evaluations, most recent trades for the same bonds and trades for similar or comparable bonds. With current technology, this entire process can potentially be automated, requiring only a modicum of human intervention.
Many years ago, back at the height of the Internet craze, I had the interesting experience of being involved with a fledgling online bond trading firm. That venture brought together a highly experienced group of muni market pros, fascinated by the promise of the internet as a potentially game-changing technology. Our vision was to provide a new platform for muni investors to access liquidity and facilitate transparency and price discovery. We came up with a state-of-the art electronic trading platform with benchmark curves derived from actual daily trade data. Most importantly, we provided potential bond purchasers with a pioneering (at the time) price discovery system that not only let them know where the same bond had recently traded but also where trades on comparable securities (“comps”) have occurred. And all this was meant to be delivered electronically with only modest human intervention.
As it turned out, we were hopelessly ahead of our time and so we failed spectacularly. However, after all these years, it is gratifying to finally see some components of our vision finally being implemented by various industry vendors. For instance, S&P Capital IQ recently started to provide clients with “comparable trades” to supplement their bond evaluations. And, of course, bond matching platforms are now sprouting left and right in response the incipient liquidity crisis in bonds.
The “institutional buy side” will be both a driver and a major beneficiary of the some of the changes we described. However, for the mutual funds who still dominate this retail-oriented market, some soul-searching is clearly in order. Fund managers can’t do much about “the Great Rotation” out of bonds into equities: asset classes fall in and out of favor with investors all the time, depending on the economic environment. What the funds can do as an industry, however, is to avoid self-inflicted wounds such as this year’s (and probably also next year’s) Puerto Rico debacle. Clearly, at least for a handful of fund complexes, some notion of “risk management” must be in order, particularly as we enter a new era of potentially rising rates and less commoditized credit issues. Let’s face it, Puerto Rico may have been a breakdown of diversification discipline, regardless of what one may view as the investment merits of PR paper. After all, isn’t “diversification” the raison d’etre of the mutual fund format? As we’ve seen this year, the sins of a minority of muni funds has led to record outflows for the entire industry and hurt everyone in the process.
Another challenge for our business going forward: how do we reach and educate the next generation of investors about the risk/return characteristics of the tax-exempt market? It’s been said that munis are traditionally sold, not bought. That may be another one of those “sacred cows” fit to be slayed. Our sons and daughters are more likely to do their own research online and reach their own conclusions well before they pick up the phone to call their brokers or financial advisors. They certainly are less prone to getting their investment recommendations between two rounds of golf. That implies a whole different way of “selling” the investment merits of the asset class. It is incumbent on our industry to come up with new ways to provide accurate and actionable investment information to the next generation, be it through social media or any other tool that may spring up in the years ahead.
If much of this still sounds like wishful thinking from an old timer, so be it. The muni market has clearly shown itself much more resistant to change than any other asset class. But change is coming nonetheless. Let this be a challenge to all you tech entrepreneurs out there: can you take this last bastion of traditionalism into the 20th century, let alone the 21st?
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Disclaimer: The opinions and statements expressed in this column are solely those of the author and Axios Advisors, who are solely responsible for the accuracy and completeness of this column. This column does not reflect the position or views of RICIC, LLC or MuniNetGuide.
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