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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

Background and Context

Market Overview

The municipal bond market consists of over $3.9 trillion in outstanding debt with households owning 51% of municipal bonds compared to only 6% of corporate bonds.

Research Scope

Study analyzes pricing practices and markups in municipal bond trades using MSRB academic data from July 2011 through December 2017 with anonymized dealer IDs.

Regulatory Framework

MSRB rules require "fair and reasonable" pricing but dealers directly profit from markups, creating potential conflicts of interest in this retail-dominated market.

High Variability in Small Trade Markups Over Time

  • Shows persistent high markups for small trades despite regulatory changes
  • Small trades consistently face markups 2-3x higher than medium/large trades
  • Little improvement in markup levels from 2005-2019 despite increased transparency

Wide Variation in Dealer Pricing Practices

  • Shows dramatic differences in markup practices across dealers
  • Some dealers consistently charge near-zero markups while others routinely charge over 2%
  • Demonstrates lack of standardized pricing in the industry

Strategic Pricing Around Yield Thresholds

  • Shows clustering of trades just above whole percentage-point yields
  • Evidence of strategic pricing to make yields appear more attractive
  • Pattern is especially pronounced for high-markup dealers

Higher Markups on Long-Maturity Bonds

  • Shows systematically higher markups on longer-maturity bonds
  • Long-maturity bonds have 1.25% higher markups than matched short-maturity bonds
  • Effect persists even after controlling for liquidity differences

Limited Impact of Regulatory Changes

  • Shows minimal effect of 2016 best execution rule and 2018 markup disclosure requirements
  • New issue markups remained largely unchanged after regulatory changes
  • Demonstrates limited effectiveness of current regulatory approach

Contribution and Implications

  • Documents systematic pricing practices that appear to exploit retail investors through high and variable markups
  • Demonstrates limited effectiveness of current regulatory framework in ensuring fair and consistent pricing
  • Suggests need for structural reforms such as increased electronic trading access for retail investors

Data Sources

  • Markup trends visualization based on Figure 1 showing markups from 2005-2019
  • Dealer variation chart based on dealer fixed effects analysis in Figure 3
  • Yield threshold clustering based on Figure 7 analysis of trade frequencies
  • Maturity markup comparison based on Table IV matched sample analysis
  • Regulatory impact visualization based on Table VI event study results