The Rise of Book-Entry-Only Bonds Comes With Costs

There is no turning back to the dinosaur days when investors with bearer bonds clipped coupons to claim principal and interest payments. As James A. Lebenthal, chairman of the municipal brokerage house Lebenthal & Co., put it, "The bond certificate is dead."

But the extinction of the bond certificate and the rise of high-tech bonds in "book-entry-only" form could cost investors money, he and other bond brokers warn.

The futuristic book-entry-only bonds, like characters in the science fiction movie Tron, exist in a computerized netherworld that eliminates the printing, registration, and transfer costs associated with old-fashioned bonds - as much as $50 per $1,000 of a bond's face value.

But those savings are offset by the administrative costs of sending principal and interest payments to investors. And increasingly, firms are deciding that they must pass those costs along to bondholders.

"People are beginning to realize that there are hard costs in book-entry bonds, and the industry is beginning to attempt to recoup that cost at the client's expense," said Steve Harris, executive vice president of Golden, Harris Capital Group Inc., in West Orange, N.J.

Mr. Harris said he recently spoke to a disgruntled investor who had been surprised by a charge that another firm had exacted for an "inactive" municipal bond account.

Such charges are not uncommon. In July 1990, New York City Comptroller Elizabeth Holtzman asked the city's bond underwriters to say whether they levied inactive account charges on their municipal bond clients. She took the action after receiving complaints from investors who bought New York City bonds in book-entry-only form and were surprised by charges from their dealers.

"That's going to become a bigger and bigger problem, as more and more firms start charging," Mr. Harris said. "People are going to be subjected to these charges, and there is no way they can avoid them."

The charges result from the fact that under the book-entry-only system, brokerages act as the registered owners of bonds they sell to clients. The bonds exist on silicon computer microchips at depositories, such as New York's Depository Trust Co., a not-for-profit that is home to $900 billion of municipal bonds.

The bonds are held in the name of the brokerage that last sold them, and the brokerages, in the case of the Depository Trust, are "participants" in the depository.

The costs of book-entry-only bond accounts seem unfair from all sides. To investors, the inactive account charges are money for nothing, charges for services they did not request and cannot decline.

To the bond houses, the responsibilities that stem from the book-entry system create increased and recurring operating costs, often on idle accounts that do not generate profits. The firms either eat the costs or pass them on to their clients.

For now, brokerages such as Mr. Lebenthal's are loath to levy inactive account charges.

Costs for Regional Brokers

"One day, if we have to charge people for sending them interest payment checks, that is going to be a horrible day - worse than the day the cake of soap sank at Procter & Gamble," Mr. Lebenthal said.

But without relief, the soap may soon sink. Particularly for regional brokers, the costs of the book-entry system are onerous. For some, it means sticking to the 40% of the new-issue market that still comes with certificates.

The brokers may not have a big enough business to benefit from economies of scale. And their client base may consist mostly of retail investors who do not have access to an agent, such as a major bank, that can serve as custodian.

Among those seeking ways to ease the burden on the regional brokers is Joseph W. Sack, vice president and director of regional services at the Public Securities Association. Mr. Sack once served as head of a Smith Barney, Harris Upham & Co. operation called the Municipal Bond Service Bureau, established in 1988. The bureau, established to provide custodial services for regional brokers, was dismantled after Smith was purchased by Primerica.

Its successor is the Dealers Cooperative Custody Program, a loose consortium of firms that team up to provide custodial services through the Bank of New York.

"It seems to be working quite smoothly, for a start-up, and we've found it to be a godsend in the administration of book-entry-only bonds, which formerly were very difficult for individuals to take delivery of and custodialize," said David M. Thompson, a principal at Griffin, Kubik, Stephens & Thompson Inc.

The consortium provides quarterly account statements and makes coupon and interest payments. It also offers a money market fund into which the interest payments can be swept.

Even with such approaches to serving investors, some still feel uneasy with the newfangled investments. They worry, for example, that fraud will become easier as physical bonds are phased out. In a recent case in California, a brokerage sold nonexistent bonds, using phony computer statements of ownership.

The swindle would have been more difficult in the days when a broker had to physically deliver a bond certificate, which requires considerably more skill to forge than a computer printout.

The newsletter California Municipal Bond Advisor, discussing the scam perpetrated by FSG Financial Services, conceded that in spite of worries about fraud, "Dislike of, or concern for, book-entry bonds is a useless exercise. Book-entry bonds are here to stay."

The Securities Investors Protection Corp. insures investors up to $500,000 per account. That has some investors worrying what would happen to bonds held in the name of a broker if the broker went bust.

In addition, the payment chain ending with the investor often causes delays, sometimes lasting as long as 10 days.

Despite the increased costs associated with the book-entry-only system, the computer-based method has continued to increase its grasp on the often stodgy municipal bond market.

The First Without Certificates

The first issuer to market bonds with no certificates was the Philadelphia Authority for Industrial Development, which in December 1982 sold $1.2 million of book-entry-only bonds. Since then, Depository Trust Co. has cleared a quarter of a billion dollars of municipal bonds in book-entry-only form.

In 1989, $73 billion in book-entry-only securities came to market, accounting for nearly half of all issuance, according to Securities Data Co./Bond Buyer.

Through the end of August of this year, an official at the depository said, Depository Trust cleared $26 billion of municipal notes in paperless form - 95% of the total short-term municipal debt for the period. In the same period, it cleared $56.6 billion of municipal bonds without certificates, some 62% total long-term municipal borrowings. In addition, variable-rate demand bonds cleared through the depository without certificates totaled $3.2 billion, or 96% of that market sector.

Market penetration has come easier in the short-term note market, which is dominated by savvy issuers not afraid to experiment, officials from the depository have said. The long-term market, which serves the full spectrum of issuers, provides a better measure of municipal response to securities that exist only in computer memory banks.

Quite a few insist that buyers want physical securities. That is a sentiment even municipal securities professionals share. "I personally like to have pieces of paper in my lock-box," said one regional broker in Nashville, Tenn.

Benson R. Cohn, assistant treasurer for debt management in Connecticut's treasury, said the state makes a point of selling certificated bonds for a college saver program because many of the bonds are bought by elderly investors who want to present bonds to grandchildren. Each year, the state sells about $120 million of college saver general obligation debt.

But most Connecticut and other major municipal market players are enamored of the book-entry-only system because it saves them paperwork.

As Zane B. Mann, publisher of California Municipal Bond Advisor, put it in his Sept. 3 issue, "The real beneficiaries [of book-entry-only] are the issuers. Analysts have estimated the savings in printing costs, registration and transfer fees, and communications costs can amount to as much as 5% over the life of a bond issue."

But even the high-tech book-entry approach, for now, generates paperwork. It is the paperwork involved in writing checks to distribute coupon and principal payments to investors that results in new costs, which have effectively been shifted from the issuers to the brokers and now are being passed on to investors.

"All of the many fingers that go into handling certificates are passe," Mr. Lebenthal said. Mailing interest checks, too, is a vestige of a bygone, paper-dependent era, he said. "Although nobody's told the customer yet. He'll find out soon enough, when we have to start charging."

Technology already offers one solution, according to Mr. Lebenthal. And that, at Lebenthal, is a tax-free money market account established free of charge for customers willing to experiment. Lebenthal deposits coupon payments the day they are due, and clients can write checks drawn on the account.

Instead of having to wait 10 days for interest payments, investors receive them electronically.

PHOTO : DTC's Securities Breakdown New issues year-to-date through August Source: Depository Trust Co.

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