October 25, 2005
Flipping Municipal Bonds
posted by Bill Sjostrom
According to a recent academic study, institutional investors are routinely flipping municipal bonds. Click here for a Bloomberg article describing the study.
Flipping is common in the stock IPO market. It involves buying shares at the IPO price and then reselling or “flipping” them once trading has begun. Assuming the stock enjoys a first day pop, as many IPOs do, it’s a relatively low risk strategy for making a quick profit. An IPO pop, however, indicates that money was left on the table by the issuer, i.e., the issuer could have sold the stock at a higher IPO price. At the same time, a little money was left on the table by the underwriters of the deal as their compensation is tied to the gross proceeds of the deal (the number of shares to be sold is typically fixed, so a lower per share price results in lower gross proceeds).
Flipping of municipal bonds is slightly different:
Let's say a bond with a 5 percent coupon due in 20 years is priced at 100, to yield 5 percent.
A big mutual fund manager gets a block of these bonds at 100. He sells them a week later at a price of 102, which has the effect of lowering the yield on those bonds to 4.84 percent.
This indicates that essentially taxpayer money was left on the table by the municipality selling the bonds:
A municipality that borrows $1 million at 5 percent pays back $2 million: $1 million in principal, and $1 million in interest. A municipality that borrows the same amount at 4.84 percent pays back $1 million in principal, and $968,000 in interest.
The underwriters, however, did not leave any money on the table here because like with an IPO their compensation is tied to the gross proceeds of the deal which are not impacted by the interest rate.
I’m not familiar enough with municipal bond underwriting to know whether there are sound reasons to under price municipal bonds at issuance, but on its face it appears questionable. There is much less guess work involved in pricing bonds than IPOs--for bonds, the market readily dictates the appropriate interest rate. It reminds me of the mutual fund trading scandal where hedge funds were allowed to engage in late trading and market timing to generate low risk profits at the expense of everyday mutual fund investors.
Note that most provisions of the Securities Act of 1933 do not apply to municipal bonds because section 3(a)(2) of the act exempts these types of securites from coverage. Section 17 (anti-fraud) does, however, apply as well as the anti-fraud provisions of the 1934 Act (rule 10b-5).
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