Dealer intermediation and price behavior in the aftermarket for new bond issues

Abstract

Roll for educating us about the structure of the muni market, and PriMuni LLC for providing the dataset. We also thank Shane Corwin, Espen Eckbo, Ron Goettler, Jean Helwege, Roni Michaely, Michael Piwowar, Enrique Schroth, and audiences at a number of seminars and conferences for helpful comments. We especially appreciate the efforts of an anonymous referee, whose comments improved the paper on several dimensions. We study trading and prices in newly issued municipal bonds. Municipals, which trade in decentralized, broker-dealer markets, are underpriced when issued, but unlike equities the average price rises slowly over a period of several days. We document high levels of price dispersion in newly issued bonds, and show that the average drift upward in price is because of changes in the mix of trades over time. While large trades occur close to the reoffering price, and close to each other, small trades occur at a wide range of prices almost simultaneously. Some small investors appear to be informed about the status of the issue, and trade on attractive terms. Others appear uninformed, and often buy at prices as much as five percent above the reoffering price, at which informed traders buy. We estimate a mixed-distribution model that highlights ex-ante characteristics that discriminate between these types of investors, and quantifies the losses uninformed traders or issuers give up to broker-dealers.

Presidential Address: Issuers, Underwriter Syndicates, and Aftermarket Transparency

“…Often the cost of acquiring information about prices for securities and financial services is not high “if you know where to look,” but time and effort are needed to educate investors about where to look. The market for new issues of municipal bonds, studied by Green, Hollifield, and Schürhoff (2007b), illustrates this. Information about the reoffering price of new bond issues is not difficult to acquire, but many retail customers do not even know a bond is recently issued when they purchase it through their broker.…”

“…Green, Hollifield, and Schürhoff (2007b), who examine price dispersion in the market for new municipal bond issues, provide the empirical study most pertinent to the model developed here. The new issues market is of particular interest because it is one time in the life of the bonds when there is a good deal of trading volume for exogenous reasons: There must be trade to move the bonds from the inventories of the dealer‐underwriters to the portfolios of investors.…”

“…The new issues market is of particular interest because it is one time in the life of the bonds when there is a good deal of trading volume for exogenous reasons: There must be trade to move the bonds from the inventories of the dealer‐underwriters to the portfolios of investors. For issues with high levels of retail participation, Green, Hollifield, and Schürhoff (2007b) show that trades occur at a wide range of prices virtually simultaneously. Some of the dispersion is attributable to trade size.…”

“…There is underpricing of new issues relative to the average price buyers pay for the bonds. Green, Hollifield, and Schürhoff (2007b) argue that the high level of price dispersion observed for retail size trades is likely due to the differences in the access investors have to price information. While it is relatively easy to find this information, many investors are unsophisticated about its availability, not knowing where to look for it.…”

“…Each dealer has preferential access to a set of retail consumers who can search across dealers for the best price at a cost. In equilibrium dealers quote prices to retail investors using a mixed strategy, leading to price dispersion of the sort documented in Green, Hollifield, and Schürhoff (2007b). ties the primary and secondary markets together.…”