Municipal Bond Trading
The secondary market of municipal bonds is in the over-the-counter (OTC) market, so many of the rules governing OTC transactions also govern municipal bond transactions.
Municipal bonds are priced on a yield-to-maturity basis rather than a dollar price, which is called a basis quote. Municipal revenue bonds, which are usually callable, are called dollar bonds because their prices are quoted as a percentage of par value. So, a quote of 105 would mean that the bond is selling for $105 for every $100 in par value.
There are several types of quotation for municipal bonds in the secondary market:
- A firm quote, also known as a bona fide quotation, is a displayed quote on a securities network terminal or a quote given by phone which is not qualified, which is the price that the dealer must pay if it is bidding or the price that the dealer is willing to sell if the quote is an offer. A bona fide quotation must reflect the dealer's best judgement and must be reasonably related to the fair market value for the security. The quote may be modified by the dealer to reflect its inventory or expectations about the market direction.
- An out-firm quote is a firm quote that is good for a specified duration, such as for 1 hour. It may also have a recall provision, where the quoting dealer can call the quoted customer or other dealer that it has another buyer, and so he will give the customer or dealer the amount of time specified in the recall provision, such as 5 minutes, after which the quoted price will no longer be firm. An out-firm quote is possible for many bonds, because most are rarely traded, so bonds do not fluctuate in price nearly as fast as stocks or other securities.
- A workable indication, also called a nominal quote, is a price that the dealer may be willing to buy or sell, but it is not a firm quote, usually because the bond is not actively traded and may not be located, so the dealer cannot give a firm quote immediately. Or the dealer may wish to negotiate the price, thus using the nominal quote as a starting price for negotiations. A workable indication may also have terms and conditions under which the dealer will be willing to buy or sell the bonds.
Regulation of Municipal Bond Dealers
Large brokerages maintain a municipal bond department that may sell to customers or to other bond dealers. A broker's broker acts as an agent for other institutional customers, such as major institutions or even other brokers. The identity of customers is not disclosed nor do these brokers maintain an inventory of bonds, since they act only as an agent.
When a dealer acts as an agent, it charges a commission for the transaction. If the dealer acts as a principal, then the bonds are bought for his own inventory, charging a markdown when securities are bought from customers, or the bonds are sold from his own inventory, charging a markup when the securities are sold to customers.
A group of investment bankers may create a secondary market joint or trading account to purchase large blocks of bonds from institutional issuers to resell. Participating firms sign agreements containing the terms and conditions in which the joint account will operate. The secondary joint account agreement creates the account, identifies the participating dealers, specifies the lead manager, the securities to be purchased, and any other terms and conditions of the account. All account members must sell the bonds at the same price and the account must be settled within 30 calendar days after the municipal bonds are purchased and delivered to the secondary joint account members.
Selling Municipal Bonds to Consumers
As with selling securities to the investing public, regulations specify the conditions under which such sales can be made. The MSRB requires the suitability test to be applied to discretionary accounts and other accounts. Municipal bonds are also more suited for people wanting income as an investment objective. Tax-free municipal bonds are more suitable for higher-income taxpayers, and they should not be placed in tax-advantaged accounts such as IRAs or 401(k) plans.
If a municipal securities firm has a control relationship with the issuer of the municipal bonds, then this must be disclosed, such as when an officer of a municipal dealer sits on the board of directors of an issuer. Disclosure can be verbal at first, but it must be written before the transaction is completed.
Dealers cannot guarantee customers that they will earn profits or will not suffer losses nor can the dealer share in the profits or losses of the customer's account, unless an Associated Person has a personal joint account with a customer and obtains written permission from the firm, and the profits and losses are proportional to the amount of capital that the Associated Person has contributed to the account.
The net price charged in a principal transaction must reflect the dealer's best judgment of the fair market value of the security, the expense of the transaction, the total dollar amount of the transaction, and the value of any security exchanged or traded. However, markups and markdowns are not disclosed to the customer at confirmation.
The commissions earned from an agency transaction must consider the availability of the securities, the expense of executing the order, the value of any services rendered, and the amount of any other compensation received or to be received with a transaction. The dealer as agent must make a reasonable effort to get a fair and reasonable price. Trying to increase commissions by churning is prohibited. Churning occurs when the dealer frequently buys or sells securities for the primary purpose of earning more commissions.