HAS FINRA FIXED THE UNDISCLOSED MARKUP/MARKDOWN PROBLEM?
I THINK NOT . . .
The Financial Industry Regulatory Authority (FINRA) recently released guidance to help securities firms implement a new rule requiring enhanced price disclosure to retail investors for trades in corporate and agency bonds. The new requirements go into effect May 14, 2018. The guidance, in the form of answers to frequently asked questions (FAQ), covers such topics as when the new disclosure requirements are triggered; the scope of securities and transactions subject to the new rule; the required content and form of disclosure; and the determination of prevailing market price. Sounds impressive, but is it?
The FAQ from FINRA coincide with parallel guidance from the Municipal Securities Rulemaking Board (MSRB), which contemporaneously is implementing similar requirements, in the effort to coordinate requirements across the various regulators of the bond markets.
It should be noted:
- The bond market is much larger than the stock market.
Bonds have exploded in popularity as a long-term trend toward lower interest rates has made financing cheaper than ever for government and corporate borrowers. Hence, they borrow money from us by issuing bonds! The global bond market has more than tripled in size in the past 15 years and now exceeds $100 trillion. By contrast, the value of the global stock market is about $64 trillion. In the U.S. alone, bond markets make up almost $40 trillion in value, compared to less than $20 trillion for the domestic stock market. The bond market is huge!
Trading volume in bonds also dramatically exceeds stock market volume, with nearly $700 billion in bonds traded on a daily basis. That compares to about $200 billion per day in volume for stocks, according to data from a well-known industry group, SIFMA. The relative size of the bond market shows how important it is in the financial industry, even if it doesn’t come as a top priority for most investors.
- Bond prices can be volatile.
Many investors have the sense that bonds are safer than stocks and conclude that they can never lose money on a bond. Wrong! Bond prices can move rapidly when interest rates change, as investors don’t want to hold a low-coupon bond when they could get a higher-paying newly issued bond instead. Much of the trading volume in the bond market is driven by issuers seeking to minimize costs of financing on one hand while investors want as much income, i.e., interest, as they can get. That dynamic creates big moves in bond prices when rates are changing, and losses can mount quickly when rates rise or the credit quality of the issuer comes into question. Remember, bonds are simply promises to repay debt at a certain point in the future, with interest payments along the way. That promise is only as good as the promiser!
- Bond ratings can be an important indicator of…
Rating agencies look closely at bonds to judge the likelihood that the issuer will be able to repay the debt obligations. They utilize various rating scales and methods to make their estimates. S&P, for instance, sets AAA as its highest broad rating, and after that, ratings of AA, A, BBB, BB, and so on down to D represent decreasing credit quality. All ratings between AA and CCC also allow for plus or minus symbols to attach to the end of the rating, indicating bonds at the top or bottom end of that rating range respectively.
An important demarcation in the bond market is the S&P ratings of BBB- which is the lowest rating a bond can have and still be considered high-quality or “investment grade”. Bonds rated lower than BBB- (Baaa3 for Moody’s) indicates debt from lower-quality, high-yield or “junk bonds” Typically, though not always (remember the Lehman Brothers bankruptcy, higher rated bonds have less chance of default, and so issuers can pay lower interest rates and still sell their bonds. The oftentimes incestuous relationship between issuers and rating agencies is an topic all its own for later analysis!
Suffice it to say that the exact ratings depend on the credit rating agency. Companies that have credit ratings which qualify their bonds as “investment grade”, historically have a very high capacity to repay their debts, with AAA rated companies having the highest capacity to repay. The next categories down double and single A ratings are assigned to bonds from companies that historically have a strong capacity to repay their financial commitments. These companies are currently stable and easily able to repay their debts, but could face challenges if economic conditions deteriorate. The bottom tier of investment grade credit ratings including the triple B’s are assigned to companies whose bonds are considered “speculative grade” and are vulnerable to changing economic conditions. These companies (and their bondholders) and could face big challenges, i.e., losses, if economic conditions deteriorate. Credit rating agencies measure credit risk. Credit risk means simply the ability of a particular company to repay its debt. Factors affecting credit risk include macroeconomic conditions generally beyond the control of the issuer, the amount of debt and expenses already incurred by the issuer, its future revenue, expenses and cash flows, to name just a few. As such . . .
- Not all bonds from a given company are created equal.
One of the most confusing things about bonds is that even when you consider a single company’s debt, the various bonds you can buy aren’t necessarily the same. Various features, and sometimes even the maturity date, may define the relative order of priority for bondholders to be repaid should the issuer find itself in financial trouble. Some bonds offer collateral to back some of its bonds. Some may issue senior or subordinated bonds that have different priorities for repayment in a bankruptcy proceeding. By contrast, most stock investors buy stock from companies that only have a single class of stock publicly available and trading, making it much easier for investors to comprehend. Of course, as a company takes on more and more debt, repayment of all becomes more and more problematic.
So is an investment in the bond market to be more complicated than it’s worth? The answer to that question is determined case-by-case. With some work, you can understand the basics of the bond market and navigate it well enough to take advantage of investing opportunities when they arise, or to steer clear from bad choices.
The rule, approved by the Securities and Exchange Commission in November 2016, will help. The rule requires that firms disclose on retail-customer confirmations the “mark-up” or “mark-down” for certain transactions in corporate and agency bonds. Still no help for smaller institutional investors, like community banks and small businesses, but helpful for Mr. and Mrs. Smith. Providing meaningful and useful pricing information will assist customers in monitoring costs and may lead to more competitive pricing by the firms who make a market in debt securities. This remains to be seen.
Under the new rule, if a firm sells or buys a corporate or agency bond to or from a retail customer, and on the same day buys or sells the same security as a principal from another party in an equal or greater amount, the firm will have to disclose on the customer confirmation the firm’s mark-up or mark-down from the prevailing market price for the security, subject to limited exceptions. So if they buy the bond at close of business Monday, and sell it first thing Tuesday morning, no disclosure. Ridiculous! Firms should disclose their costs to buy the bonds or proceeds from selling and how long they held the bond in inventory, be it .01 seconds or 184 days! Savvy bond investors know that most of this data is already available on EMMA (for municipal bonds) and on TRACE, FINRA’s Trade Reporting and Compliance Engine (for corporate and agency bonds).
The information is there. Now go get it!