Beware of Municipal Bonds

Beware of municipal bonds. If they sound too good to be true, they probably are. Your Survival Guy is not a fan. One problem with munis is disclosures. At ProMarket, David Dubrow and Kent Hiteshew explain some improvements that could be made to the system, writing:

Part one recounted the history of how the municipal bond market was exempted from regulation under the Securities Acts adopted in the 1930s and how the SEC, beginning in the 1970s, used its anti-fraud powers over broker-dealers to partially overcome the statutory exemption. Notwithstanding these efforts, municipal bond disclosure remains ungoverned by uniform disclosure standards.

As noted in Part one, the only two major municipal regulation efforts followed significant market failures: the 1975 Amendments and creation of the MSRB following New York City’s financial crisis; and, Rule 15c2-12 following the WPPSS default in the 1980s. So, it is particularly noteworthy that there has been virtually no relevant federal legislation enacted or SEC regulations issued in the wake of the far larger investor losses experienced by municipal investors after the historic Detroit and Puerto Rico bankruptcies of the last decade. In fact, with the exception of a single broker-dealer affiliate’s closed-end bond funds, there have been virtually no SEC enforcement actions brought against any of the Detroit or Puerto Rico parties. Accordingly, it may be an appropriate time to revisit the unique exemption from uniform disclosure standards of the Securities Acts that continues to plague the municipal bond market.

There are two potential approaches to making municipal offering statements subject to improved disclosure standards. If Congress were to repeal the Tower Amendment and amend the Securities Acts, the SEC and MSRB could directly regulate offering statements by setting forth specified disclosure requirements. The second approach would expand the SEC/MSRB anti-fraud regulatory authority over broker-dealers to include specified disclosure requirements within its existing Rule 15c2-12. To be clear, we are not advocating to subject municipal issuers to pre-sale registration and SEC filing. Given the number of municipal issuers and volume of issuance, this would be extremely disruptive. Furthermore, it is not clear that such pre-sale registration would represent a meaningful benefit in light of relatively low municipal default rates and existing disclosure regimes created by Rule 15c2-12.

Our preferred statutory approach would have the advantage of creating a regulatory scheme with consistent disclosure standards. Statutory authority would remove broker-dealers as the SEC/MSRB’s surrogate, providing the SEC with the authority to enforce issuer compliance with both offering statements standards and CDA reporting obligations. In addition, in setting broad disclosure standards, Congress could direct the SEC to differentiate among different classes of municipal issuers. For example, conduit borrowers should be treated more akin to the corporate-like issuers they truly represent and subjected to more rigorous standards consistent with their much higher default experience. In addition, small, infrequent governmental issuers might be afforded more abbreviated standards than larger, regular governmental issuers.

Of course, bi-partisan Congressional support for such reform will be very difficult to achieve, especially in the face of anticipated strong municipal issuer resistance. Such opposition would be unfortunate and shortsighted as uniform disclosure standards would translate to improved liquidity and secondary market pricing. This should ultimately lower borrowing costs for state and local governments.

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E.J. Smith - Your Survival Guy

E.J. Smith is Founder of YourSurvivalGuy.com, Managing Director at Richard C. Young & Co., Ltd., a Managing Editor of Richardcyoung.com, and Editor-in-Chief of Youngresearch.com. His focus at all times is on preparing clients and readers for “Times Like These.” E.J. graduated from Babson College in Wellesley, Massachusetts, with a B.S. in finance and investments. In 1995, E.J. began his investment career at Fidelity Investments in Boston before joining Richard C. Young & Co., Ltd. in 1998. E.J. has trained at Sig Sauer Academy in Epping, NH. His first drum set was a 5-piece Slingerland with Zildjians. He grew-up worshiping Neil Peart (RIP) of the band Rush, and loves the song Tom Sawyer—the name of his family’s boat, a Grady-White Canyon 306. He grew up in Mattapoisett, MA, an idyllic small town on the water near Cape Cod. He spends time in Newport, RI and Bartlett, NH—both as far away from Wall Street as one could mentally get. The Newport office is on a quiet, tree lined street not far from the harbor and the log cabin in Bartlett, NH, the “Live Free or Die” state, sits on the edge of the White Mountain National Forest. He enjoys spending time in Key West (RIP JB) and Paris. Please get in touch with E.J. at ejsmith@yoursurvivalguy.com To sign up for my free monthly Survive & Thrive letter, click here.

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