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Do Municipal Bond Dealers Give Their Customers 'Fair and Reasonable' Pricing?

Journal: Journal of Finance

Date: 20230401

Author: Griffin, John M.; Hirschey, Nicholas; Kruger, Samuel

Abstract:
Municipal bonds exhibit considerable retail pricing variation, even for same-size trades of the same bond on the same day, and even from the same dealer. Markups vary widely across dealers. Trading strongly clusters on eighth price increments, and clustered trades exhibit higher markups. Yields are often lowered to just above salient numbers. Machine learning estimates exploiting the richness of the data show that dealers that use strategic pricing have systematically higher markups. Recent Municipal Securities Rulemaking Board rules have had only a limited impact on markups. While a subset of dealers focus on best execution, many dealers appear focused on opportunistic pricing.

Link: Google Scholar

Key Findings

High Markup Variability

Municipal bond dealers charge significantly variable markups on same-size trades of identical bonds, even from the same dealer on the same day. Markup differences of 0.5% or more occur 61% of the time for new issues.

Strategic Pricing Practices

Dealers use strategic pricing practices including clustering at round numbers, targeting yields just above whole percentages, and charging higher markups on long-maturity bonds where markup impact is less noticeable.

Limited Regulatory Impact

Recent MSRB regulatory changes requiring best execution and markup disclosure have had minimal impact on reducing markups or improving pricing consistency.

Markup Variation by Trade Size

  • Small trades (≤$100k) consistently have higher markups than medium ($100k-$500k) and large (>$500k) trades
  • New issue small trades have median markup of 1.33% vs 0.024% for large trades
  • Seasoned issue small trades have median markup of 0.946% vs 0.018% for large trades

Strategic Pricing Around Whole Percentage Yields

  • Trading strongly clusters just above whole percentage yields
  • 3x more trades occur in 0.005%-0.015% range vs 0.985%-0.995% range
  • Markups are 24-30 basis points higher for trades just above whole percentage yields

Impact of Regulatory Changes

  • Best execution rule (March 2016) had no significant impact on new issue markups
  • Markup disclosure rule (May 2018) led to only minor reductions in seasoned issue markups (-5.6 bps)
  • Extreme markups (>3%) remained prevalent after both regulatory changes

Contribution and Implications

  • Documents widespread pricing inconsistencies in municipal bond market despite regulatory requirements for fair and reasonable pricing
  • Identifies specific dealer practices that may exploit retail investors' limited attention and cognitive biases
  • Suggests need for stronger regulatory enforcement and potential market structure reforms to improve pricing efficiency

Data Sources

  • Trade size markup comparison based on Table I regression results showing markup differences across size categories
  • Strategic yield pricing analysis derived from Figure 7 showing trading frequency around whole percentage yields
  • Regulatory impact analysis based on Table VI event study results around MSRB rule changes