Many factors affect the pricing of municipal bonds, both during an initial offering, called the “primary market,” and in later “secondary market” trading. Some of these factors that affect the price include credit quality, interest rate movement, liquidity in the market, and the prevailing interest rates for similar bonds.
Basic Terminology
Before exploring the additional factors that affect the pricing of a municipal bond, it is essential to understand the terminology related to municipal bond pricing. The price of a municipal bond is expressed as a percentage of the principal or par value of the bond, which is usually $1,000. So, a bond trading at par is said to be trading at 100, or $1,000. A bond quoted at $105 is trading at a premium at 105% of par, or $1,050. A bond quoted at $95 is trading at a discount at 95% of par, or $950. Municipal bonds are typically sold in minimum denominations of $5,000.
Primary Market Pricing
The two most frequently used methods of pricing municipal bonds in the primary market are through a competitive or negotiated sale. Issuers or obligors (borrowers ultimately responsible to pay interest and principal on the bond), along with their municipal advisor (if they retain one), will determine the best method for pricing their bonds after weighing various factors regarding their bond issue and any goals the issuer/obligor may be trying to achieve. Pricing for both methods is determined by evaluating current market conditions, similar deals pricing in the marketplace, investor demand and trades of similar credits in the secondary market.
Competitive Sale
In a competitive bond sale, the issuer/obligor of the bonds publishes a notice of sale outlining the structure of the issue and alerting potential underwriters of the date and time the issuer/obligor will receive bids from each underwriter or syndicate group that may have been formed to bid on the bond issue. The issuer/obligor awards the bonds to the underwriter or syndicate offering the lowest total interest cost. The award results in a contract with the issuer/obligor in which the underwriter or syndicate agrees to buy the bonds and offer them to the public at those prices submitted in their bid.
Negotiated Sale
In a negotiated bond sale, the issuer/obligor will hire an underwriter or group of underwriters (syndicate), through a request for proposal (RFP) process or some other method to sell their new bond issue. The underwriter or syndicate will work with the issuer/obligor, along with their municipal advisor (if one is retained), to determine the structure of the bond issue and the priority of orders. A negotiated bond sale consists of a process of premarketing the bonds to the investor group or groups determined by the issuer/obligor. These investor groups may include individual investors and/or institutional investors, such as banks, mutual funds and insurance companies etc. On the day of pricing, an order period is established to submit confirmed orders and determine investor interest. At the conclusion of the order period, the senior underwriter will make any appropriate price changes and propose the final pricing to the issuer/obligor for their acceptance and confirm with a “verbal award.” Shortly thereafter, the contract between the issuer/obligor and underwriter, known as the Bond Purchase Agreement (BPA), is signed and will establish the “formal award.”
Secondary Market Pricing
Prices for bonds trading in the secondary market are set differently than those in the primary market. For an investor purchasing or selling a municipal bond in the secondary market, a broker or municipal securities dealer (financial firm) executing the transaction must offer a fair price and use reasonable diligence to determine the best market for the municipal security, known as best execution. Best execution is designed to help ensure investors receive fair and reasonable prices for their transactions and better execution quality, while promoting fair competition among brokers and improving market efficiency.
Generally fixed rate municipal bonds pay interest on a semiannual basis, although they can have different payment periods and dates, such as an annual payment. Depending on the date your trade occurs, some accrued interest may be applied to the trade. MSRB rules govern the way accrued interest is calculated.
Fair Prices
There are well over one million outstanding municipal bonds, which are identified by a unique identifier called a CUSIP number. Because of the large number of outstanding municipal bonds, the financial firm’s determination of a fair price involves multiple factors, which include prices paid on recent trades of the security, trades of similar securities, and the use of economic models.
Depending on the role the financial firm plays in the transaction (principal, agent or adviser), the firm may receive a commission on the trade or add a markup to the purchase price. When a firm acts as a principal, it is selling a bond it owns, even if quite briefly. The firm is required to charge or pay the investor an “all-in” fair price that includes the firm’s markup or markdown. In contrast, if the firm acts as an agent, it finds a seller or buyer elsewhere in the marketplace who has or wants the security the investor is looking to buy or sell. The firm acting as agent will impose a reasonable sales charge on the transaction. To learn more about different types of investment services, see Ways to Buy Municipal Bonds.
Markups and Markdowns
When a firm sells you a bond on a principal basis, the firm’s compensation for its services, or markup, is built into the price you pay for the bond. The firm that sells you a municipal bond must send you a confirmation statement reflecting certain details of your trade, including the amount of markup if the firm bought and sold those bonds on the same day.
If you wish to sell a bond you own, your financial firm will conduct research to determine what it believes is a fair price for the bond, and a markdown is built into the price the firm will pay you for the bond as compensation.
When the markup or markdown is disclosed on your confirmation, it will be displayed as a total dollar amount and as a percentage of the prevailing market price of the municipal bond. Remember that the markup or markdown is not an additional itemized fee paid to the firm but instead is included in the price of the bond.
