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Uncovering the Spread

Will greater disclosure in the corporate bond market lower the cost of debt? Issuers may soon find out.

Ian Springsteel, CFO Magazine

February 01, 1999

In markets for the likes of narcotics and arms, prices fluctuate wildly day to day, quotes change in mid-conversation, trades are effectively unregulated, and middlemen walk away with billions in profits. That also accurately describes the U.S. corporate bond market, where 98 percent of the $10 billion in daily trading occurs over the counter, with no public disclosure and little oversight by Uncle Sam. Critics say that raises the cost of issuing and trading bonds.

Not that the government hasn't been interested. Since the Securities and Exchange Commission was first granted the power to require electronic price reporting and develop market surveillance programs in 1975, the market regulator has looked several times at creating such a system, to no avail. With relatively little retail investor exposure, and more immediate problems to be addressed in the equities markets, past commissions always let the issue slide.

Yet SEC chairman Arthur Levitt has decided to revisit the issue, announcing an initiative last September to create a new system of publicly available corporate bond price reporting, along with a new supervisory and regulation database system, with the help of the National Association of Securities Dealers (NASD).

"The sad truth is that investors in the corporate bond market do not enjoy the same access to information as a car buyer, a home buyer, or, dare I say, a fruit buyer. And that's unacceptable," said Levitt, at the Media Studies Center in New York, in announcing the plans.

In fact, there's reason to believe the SEC won't back away from the issue this time, if only because powerful members of Congress are pushing for action. Yet the details of any reporting system remain the subject of heated disagreement. Bond dealers, voicing their concerns through their trade group, the Bond Market Association (BMA), are vehemently opposed to the disclosure of bid and ask quotes on the system, or any other information that would give investors more information about the markups they collect in their trading.

Yet the die-hard proponents of price transparency say that is the crux of the issue--that dealers unfairly scalp both the rare individual investor and the less-sophisticated institutional buyers because of the lack of easily available information. The result is billions of dollars a year of unproductive transactional costs in the bond market, costs that are eventually paid for by issuers in wider spreads when placing or calling their own issues.

The NASD-run system would provide real prices, an improvement over the current system of informal quotes from bond traders and guesswork valuation models. At a glance, issuers could see where their more actively traded debt is priced, allowing for more informed decisions about issuing new debt, the type of debt to issue, and the possible call or open-market repurchase of debt.

"I never know exactly where the debt of similar credit companies, or even our own debt, is trading," says James Rutledge, vice president and treasurer at the $2 billion (in sales) Witco Corp., a specialty chemicals company in Greenwich, Connecticut. "So any better pricing information than what exists now would be great. It would help us make decisions about future issues and buybacks."

Adds Larry Raymond, assistant treasurer for capital markets at Sears, Roebuck and Co., in Hoffman Estates, Illinois: "Even if you're sophisticated, you call around in this market and get lots of different prices for any particular security. There are many different positions and assumptions out there, so it would be good to see the real transaction prices."

Fuzzy Definitions

The basic concept for bond price reporting--transparency--seems fairly simple: Report as soon as possible the last time a bond traded, at what price, yield, and volume, and holders of similar bonds will have a much better gauge of what their portfolio is actually worth. But the obstacles to increasing transparencies are formidable.

NASD chief operating officer Patrick Campbell, who is overseeing the creation of the new system, says he is committed to one that creates price transparency, as called for by the SEC. But Campbell says the impact on dealers will depend on the deliberations of a newly named blue-ribbon panel--composed of senior bond market traders, institutional buyers, issuers, and other interested parties--that the NASD set up last fall.

The SEC itself is wary of imposing its own definition of a transparent transaction report. "We don't have a preconceived notion of what will be required, or when it should be released," says Belinda Blaine, an associate director in the market regulation division of the SEC. "Certainly the price and yield of the last trade should be there, and that would include all trades by broker-dealers and between them," Blaine says. "But should every trade be reported, especially very infrequent trades? Should trades be identified as being from or to a broker-dealer? We don't know. We want the most transparency that makes sense, and are open to suggestions from the NASD panel."

So what do the experts think would make sense? They aren't saying. Numerous calls to such major bond broker-dealers as Goldman, Sachs; Lazard Freres; CS First Boston; and Morgan Stanley went unreturned. The BMA contends that transparency would lead to a less liquid and more volatile market. That's because dealers' profits would be squeezed so hard, many would no longer make a market in the securities.

One major dealer dismisses that fear, at least in private. "We make money in lots of different ways," observes the chief fixed-income strategist for a major Wall Street bond firm. And while he concedes that smaller dealers might have a harder time making money as a result of smaller spreads, much as they did in equities after the SEC did away with fixed commissions in 1975, this executive doubted that would have any more impact on liquidity in the bond market than dwindling commissions did on liquidity in the stock market. As far as his firm is concerned, the fixed-income strategist says he's "fully confident" that transparency would not threaten its profits on bonds. And while he thinks change will be slow to come, he says that despite dealer resistance, he has little doubt that a public exchange will eventually come to dominate the corporate market.

No one really knows what impact corporate bond transparency will have. There is, to be sure, a new bond pricing disclosure system in the municipal market, created by the Municipal Securities Regulatory Board (MSRB), an organization designed by Congress to oversee the $2.4 trillion (principal outstanding) municipal bond market, in which 33 percent of investors by dollar volume are individuals. The new transaction reporting system reports the high, low, and close price of any muni bond that traded at least four times, on a next-day basis. To show its support for price transparency in general, and because so few newspapers will run the daily quotes, the BMA has decided to publish the 1,300 to 1,500 daily municipal-bond quotes on its Web site.

Christopher Taylor, executive director of the MSRB, says it's too soon to tell what impact, if any, the new setup has had on the municipal bond market's liquidity. But, he says, "We expect more participation and more trading to follow the increase in transparency."

Marginal Issues

While the current level of dealers' profits is a well-kept secret, some measure of trading revenues is possible, thanks to two recent studies that have tried to gauge average bid-ask spreads and their variation between 1995 and 1997.

In the first, by Arthur Warga, then professor of finance at the University of Wisconsin and now at the University of Houston, and Gwangheon Hong, a visiting assistant professor in finance at Wisconsin, average trading spreads in the large-scale over-the-counter market were 13 basis points for investment-grade bonds and 19 basis points for high-yield debt.

The second study, by Paul Schultz, professor of finance at the University of Notre Dame--one of the authors of the influential study of Nasdaq trading practices that led to changes in that stock market system and an antitrust settlement with the brokerage industry--shows wider spreads of about 26 basis points for corporate investment-grade bonds.

When multiplied by the average annual trading volume in corporate investment-grade debt--approximately $260 billion a year by the BMA's last count--an average spread of 26 basis points would add up to more than $676 million a year. If investors are losing, say, just 5 basis points a year because of a lack of transparency, that would be $135 million a year of lost yield that, theoretically, could be shaved off all outstanding corporate-bond coupons in a given year or added to investor returns.

Ian Springsteel is a freelance writer based in Boston.