Municipal Market Moils

May 20, 2016

It has been quite a disconcerting time for those investors active in the US Municipal Bond market. Following the Edward Jones settlement in the primary markets last summer (which may yet have implications for new issue pricing) and in the midst of the Puerto Rico credit crisis, two longstanding post-trade market operating customs have also been upended, requiring a fundamental reassessment of Muni fund practices.

Ian Blance

Managing Director, Voltaire Advisors LLP

Changing Vendors

First, in December 2015, Bloomberg acquired the Barclays Risk Analytics & Solutions business which included the widely tracked Barclays Municipal Bond Index family (previously Lehman’s). These indices are a common performance measurement benchmark amongst Municipal Bond funds and their constituents have been priced for many years by Interactive Data and its antecedents.

Interactive Data itself had been bought by Intercontinental Exchange (ICE) that same month, and in March of this year, ICE announced that it also planned to purchase Standard & Poor’s Securities Evaluations (SPSE). Interactive Data and SPSE are the two dominant providers of evaluated prices for the Municipal Bond mutual fund market, thus raising the prospect of this critical service being in the hands of a single player.

Index Issues

It was clear that Bloomberg was not going to be happy that a competitor was pricing their new index family when they had their own Muni pricing service in BVAL. Sure enough, plans are afoot to replace the Interactive Data constituent pricing with Bloomberg’s own. This is a pretty big deal for index users, since they will need to align their pricing sources elsewhere in the firm if they are to avoid an unwanted tracking error when comparing their own fund performance to the benchmark.

Users of the Bloomberg Muni indices have two choices if they want to avoid this: switch their Muni fund pricing to BVAL, or change the index they track. Both of these options involve significant operational, commercial and legal challenges at a time when the Muni market is in a moil, and mutual funds in general are being subject to increasing regulatory demands from the SEC.

For example see the details of our recent NY Workshop

Pricing Problems

With respect to indices, despite the potential switching pain, at least there are viable and battle-tested alternatives available to funds (notably from BAML and S&P Dow Jones). The same cannot necessarily be said for evaluated pricing services.

It is common for a mutual fund to use a primary pricing provider for its fund valuation, comparing this to a secondary source for quality assurance purposes. In a large number of cases, where the primary provider is Interactive Data, the secondary has been SPSE, and vice versa. Assuming that the ICE purchase of SPSE goes through, there is some uncertainty as to whether ICE plans to merge the two services or continue to operate them as independent entities behind Chinese walls.

In the former case, then an alternative source will need to be found to maintain the dual pricing set-up. If the latter, then arguably the existing primary/secondary arrangements could be maintained, although there would certainly be some disquiet about how independent the two sources would truly be.

Much has been made on this deal creating a monopoly in the Muni evaluated pricing market, with all the implications for market power and potential price gouging, but this not really true. In addition to BVAL already mentioned, both Markit and Thomson Reuters also have Municipal Bond evaluation services. There are also a range of smaller, niche operators.

The real issue is not that there are no alternatives, rather that the market does not want to be forced to switch to them! As previously mentioned, the de facto duopoly of Interactive Data and SPSE in the Muni mutual fund segment has prevailed for a long time and firms have become accustomed to their service offering, support systems and methodologies. Changing this, as we opined in relation to the index issue, is a major vexation.

Operational Headaches

Funds and their advisers and administrators will need to operationally migrate to a new source, dealing with new feeds, price exceptions (possibly including historical differences), new price challenge and client service arrangements and the like. They will also need to update their valuation policies and procedures, contract with, and perform due diligence on, a new vendor, and might even have to change their fund prospectus to accommodate a new service provider.

In addition to these operational headaches, another reason why funds are reluctant to switch to the alternative sources is that these are relatively unproven in the mutual fund segment when compared to the two incumbent hegemons. Whilst the vendors providing them are well established and sound, their Municipal evaluations services are all relatively new, and in the traditional – some would say parochial – Muni market, this is a cause for concern.

There is also a suggestion that the dependencies of some of these services on the same sources for reference data and pricing technology mean that they are perhaps not as completely independent from each other as funds would prefer.

A Sea Change in the Industry

Little wonder that mutual fund users are less than thrilled at the extra work these developments represent, even if Bloomberg and ICE are putting a spin on their acquisitions as being positive for the market in the future.

Our own view is that this represents a sea change in the Municipal Bond pricing and performance measurement landscape and the market needs to accept and adjust to this. Whatever happens with Interactive Data and SPSE under ICE ownership, users should start planning now for this new pricing and index world.

Looking specifically at how these developments impact a fund’s operations both now and in the future is a regulatory requirement for the fund directors and its officers anyway, so the SEC will certainly expect to see this assessment in board discussions and minutes.

Should a change in, or addition of, a pricing service provider be required, the Commission also expects appropriate due diligence to be done on the vendor before engaging them (as discussed in a previous blog 'Caveat Emptor Redux'.) This necessarily takes time, as does the migration process from one vendor to another, so it is prudent to start evaluating the alternative options in some detail now.

As a famous General once said, time spent in reconnaissance is seldom wasted!