The Muni E-Bond Revolution

With computers able to process tons of information quickly, the complicated muni market is a natural for electronic trading.
April 2000
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

Move over, day-trading stock jockeys. The fixed-income securities market and its dowager queen, the municipal bond market, are coming to a computer screen near you.

This is good news for states and localities that issue debt. The offering and trading of bonds on the Internet should save money on bond issuance and make it less expensive for investors to trade their bonds.

The changeover will happen quickly. Recent forecasts by bond experts are that, in terms of dollar values, 37 percent of all U.S. bonds traded in the market will do so on the Internet next year. That would be up from 5 percent of such trades in 1998. Munis will not lag the corporate sector. In fact, muni bonds have been out ahead when it comes to selling new issues over the Net.

This is quite a leap for the muni market, which has long been steeped in archaic charm and mystique. It's been a "telephone market," with no central tape or trading floor, and it depends on dealer-to-dealer brokering. If you, as an investor, wanted to buy or sell, you would call up dealers and have them get you quotes. You would have to depend on a dealer to execute the transaction over the phone on your behalf. There was a lot of trust involved, since there were no tickers or agate-type newspaper tables to read.

It was a primitive, personal way of doing business. Now, with the ability of the computer to search, collect and process tons of information in no time at all, the complicated municipal market is proving to be a natural for electronic trading.

"Tradition" permeated issuance as well: An entire bond issue was offered at auction to potential underwriters; these underwriters then reoffered the bonds to the market. About two years ago, some issuers began to offer bonds to dealers over the Internet. This past November, Pittsburgh, which was one of the pioneers in electronic auctions to dealers, sold bonds over the Internet directly to institutional investors.

Now, the floodgates are open. One result is the driving down of typical underwriting spreads from $5 per $1,000 of bond value to $2.50.

That is not good news for the health of the underwriting community, and it is a problem for the market as a whole. The argument is usually made that underwriters subsequently acting as traders in the secondary market are needed to provide liquidity. That is, they continue to trade bonds when markets are thin because they "know the credit" and have certain customer loyalty to the investor who wants out.

As key players in the muni market, underwiters aren't standing idly by during the e-trade upheaval. A recent report by the Bond Market Association indicates that there are about 30 firms offering e-trading among dealers and investors, with individual investors included just recently.

The secondary market, where muni bonds are traded after the initial sale, has always been sporadic. Except for during a few days after issuance, not many muni bonds trade much. That is not likely to change, but the way in which the trades take place is likely to become Internet-based as well.

In the new-issue market, government issuers may elect to sell directly to investors. One normally thinks of municipal bond investors as being highly institutional--the only big players that really count are establishments such as banks and insurance companies. There's now a new twist to that picture: The big source of capital is the individual, either investing directly or through mutual funds. Bond funds are important players in the muni bond market, but they are at risk from the move to Internet auctions because they may lose individual investors who don't want to pay management fees when they can buy directly. Thus, individual investors may hightail it away from funds and start buying direct.

There is something of a precedent for governments selling municipal bonds directly to individuals. In periods of high interest rates, some adventuresome issuers have sold small-issue "minibonds" directly to local investors. The rap on minibonds was that it was more costly to sell directly to individual investors than to go through regular channels to institutional investors. But the principle that direct sales were possible got some early testing.

With the e-trade revolution in full swing in the bond markets, issuers will increasingly auction bonds directly to investors. That will include individual investors, who shoulder the bulk of the load when it comes to holding tax-exempts. This end run around broker- dealers will be a test for Wall Street.

That's not to say there is not a place for the market makers; they are essential for new offerings that are innovative or risky. But good old garden-variety general obligation and revenue bonds may be headed for the computer screen. That should mean more trading by individuals and institutions. Machines, rather than people, will make faster trades and be less expensive matchmakers.