The current debate and stories that have appeared in The Bond Buyer about negotiated versus competitive bidding have focused on how negotiated bidding has corrupted the political process through the soliciting of campaign contributions by elected officials involved in the underwriter selection process. This is certainly a powerful argument for requiring broader use of competitive bidding in how over $250 billion in new municipal debt is sold, but there is another more compelling reason to move away from negotiated underwriting.
Bond issues sold through negotiated bids are largely presold by the underwriters well before they are actually taken down. The presales are invariably made to large institutional holders such as bond funds and insurance companies. This results in few if any bonds ever becoming available for small retail investors. Such investors have become the backbone of the municipal bond market since the Tax Reform Act of 1986 took away most alternative tax shelter investments. Despite the rapid growth of bond funds, direct household investment still makes up over 50% of the market.
What is happening today is that retail investors seeking municipal bonds are steered toward bond funds by most retail brokerage firms. Those who want to own bonds directly must therefore seek out a firm dealing in municipal bonds and must buy in the secondary market and pay commissions and markups. Such secondary market offerings also come without a prospectus, so the customer has only the vaguest notion of what he is buying.
Negotiated bidding is at the heart of the process that denies access to new issues by the general public. A few large firms dominate the new issue market and assure that institutional orders are filled first. Many of these firms have no retail customer base and even those that do have every reason to steer the offerings toward the big buyers. The takedown of the new issue volume is in fact a business generator for bond funds since, by denying individuals access to new issues, it forces them to invest via a bond fund. This process is being greatly accelerated by the current low interest rate environment in which hundreds of billions of dollars are being called through reissuance. This process is cashing out individual holders who now have little recourse but to reinvest in a bond fund.
Some may suggest that it is in fact desirable to have investors purchase through a bond fund rather than directly. Hence, they would argue that forcing bondholders into a bond fund vehicle is positive. We would disagree.
Bond funds require investors to pay a management fee for portfolio selection and risk management advice which they may or may not need. For some, it is a fee they pay for access to the market. The clearest example of this are the insured bond funds where one is paying a management fee despite the risk having been defeased (and paid for through lower yield).
A more compelling argument for preserving the individual retail investor market, however, is the fact that a one-dimensional institutional market carries a risk to the market system as a whole. Fund investors tend to have a herd mentality when it comes to selling their holdings. Hence, we see major swings in the net inflow or outflow of investment in bond funds. If the direct retail market disappears, no one will be there when bond funds are faced with sizable net fund outflows and need buyers in order to raise funds to meet the liquidations. Given normal market factors, this need to sell despite the dearth of buyers will drop the price level of all bonds. This in turn will reduce fund share valuations, precipitating even more liquidations.
The above scenario has an analogy in the 1991 collapse of the high yield bond market. That market suffered from a lack of diversity in the composition of its buyers. When those buyers found themselves compelled to sell, there were no buyers and market values crashed. Note that it took well over a year for new buyers to appear, during which time few new issues could be sold. Certainly this lack of a new-issue market figured in deepening and prolonging the recession. Competitive bidding for municipal bonds will not, alone, guarantee that the retail investor market will be preserved. It will, however, preserve the opportunity for free market forces to operate and decide what's best.
