When the West Contra Costa Unified School District in California needed money to repair and upgrade deteriorating classrooms, it hired Piper Jaffray Cos. to sell $191 million of municipal bonds.As far as school officials knew, the March 2016 sale went off flawlessly, enabling the district to refinance older debt and tackle tasks such as removing asbestos and upgrading science labs.
However, within a day of the initial sale, the original buyers sold, or “flipped,” $35 million of the district’s bonds for a profit of $306,000, a Wall Street Journal analysis of trading in the bonds found. Within 10 trading days, the post-offering trading had generated $1.24 million of market-adjusted profits.
participated in some of that trading, buying back bonds and reselling them. Newly issued municipal bonds, which are marketed as long-term investments, aren’t supposed to trade like that. The post-offering buying and selling suggests West Contra Costa’s bonds—sold in what is called a negotiated offering—were initially underpriced. That means the district will pay more in interest over the life of the bonds than it would if the bonds had been priced closer to what subsequent investors paid. “That’s money being left on the table that costs taxpayers and rate payers and governments,” said
who recently retired after 30 years as a financial adviser to local governments issuing bonds. “That’s not the way it’s supposed to go.”
The Journal analyzed all trading in newly issued municipal bonds* between March 2013 and November 2017. Those bonds had a face value of:
The Journal analyzed all trading in newly issued municipal bonds* between March 2013 and November 2017. Those bonds had a face value of:
Big investors who bought some of those bonds sold them within one day of the offering. Those ‘flipped’ bonds had a face value of
Those quick sales generated profits of
By the end of 10 days of trading, the prices of many of those bonds had risen further. Market-adjusted profits from all of the post-offering trading totaled
A Journal analysis of municipal-bond data found such post-offering trading to be routine. About $60 billion, or roughly 5%, of newly issued bonds in negotiated offerings between 2013 and 2017 were sold to customers who turned around and sold them to dealers within a single day of the initial offering, usually for a profit, the Journal found. Prices on those flipped bonds were then marked up further as they were sold to longer-term investors, bringing the total market-adjusted profits to more than $900 million. The Journal’s investigation found that those profiting from the flipping often include the banks hired to price and sell the bonds. Piper Jaffray, which was paid about $500,000 to act as the lead underwriter, said in a written statement that the California school-district bonds were priced “fairly and successfully.” It said: “Our secondary market trading was a small fraction of the total trading volume.” The district’s financial adviser,
of municipal advisory firm KNN Public Finance, briefed the school board not long after the bond sale, deeming it “very successful.” After the Journal shared its findings about post-offering trading with the West Contra Costa district, then-Associate Superintendent
said that those findings “are deeply concerning and would undermine the faith bond issuers have in the municipal market.” Although underwriters often make money by reselling flipped bonds, that doesn’t appear to be their primary motive. Underwriters are obligated to purchase any bonds they can’t place with customers, which ties up cash and exposes them to risk. So they have an incentive to price the bonds to move—and, if necessary, to sell them to customers who have no intention of holding them for long. When those customers want to sell, the underwriter often will step in to buy. Under federal rules, underwriters have a duty to set prices that are “fair and reasonable” taking into consideration all relevant factors, including their “best judgment” of the fair market value. In recent years, the Securities and Exchange Commission has begun enforcement efforts aimed at protecting issuers during the pricing and sale of bonds.
The Securities and Exchange Commission has begun enforcement efforts aimed at protecting issuers during the pricing and sale of bonds.
Stephen Voss for The Wall Street Journal
In June, the SEC announced a settlement with an underwriter for selling bonds for the public library in Harvey, Ill., “at a price which was below market price for comparable bonds.” The SEC said the underwriter, IFS Securities, failed to make a sufficient effort to market and place the debt. The settlement marked the first time the SEC has determined that underwriter pricing behavior violated the fair dealing standard, even though there was no fraud or misrepresentation. IFS, which didn’t admit or deny the findings, didn’t respond to requests for comment. The identity of buyers and sellers of municipal bonds isn’t public information. The Journal identified some using regulatory reports insurers file with the National Association of Insurance Commissioners, or NAIC. During the period of the Journal’s analysis, insurers bought and quickly sold $3.7 billion of newly issued municipal bonds, the filings show. Of that total, $2.6 billion, or 70%, was sold back to the underwriter that had just priced and sold the bonds. The underwriter paid the insurer more than the initial price 88% of the time. That pattern played out with a $3.7 million bond that was part of the West Contra Costa offering:
On the first day of trading, the lead underwriter, Piper Jaffrey, sold all of the bond in five trades at the offering price of 97.735.
Two of the customers who bought a total of $2.35 million in bonds in two trades sold, or ‘flipped,’ the bonds within a day.
One of those customers, insurer Safety National Casualty, sold its bonds back to Piper Jaffray at a price of 98.650, giving it a profit of $10,065.
Piper Jaffray then sold the same amount to another dealer at a price of 98.750, for a profit of $1,100.
Dealers that bought from Piper Jaffray also resold the bonds at higher prices. At the end of nine days of trading, most of the bonds were owned by long-term investors, who paid on average 2.8% more than the offering price.
In recent months, municipal-bond prices have risen following years of decline in borrowing by state and local issuers due to changes in tax law and financial constraints on governments. When cities and school districts decide to sell municipal bonds, they engage securities firms to underwrite them. Generally, the public entities have two options. They can put the bonds up for competitive bids and award them to the securities firms that price them with the lowest interest cost. Or they can choose an underwriter in what is known as a negotiated offering. Negotiated offerings account for about 75% of the money raised in bond offerings. Suppose a town needs to raise $20 million to build a new town hall. The securities firm it selects as lead underwriter examines the town’s finances, as well as interest rates for U.S. Treasurys and other municipal bonds. Then it gauges investor appetite for the town’s bonds at different interest rates and maturity dates. The underwriter, after consulting with the issuer, slices the total amount to be raised into a series of bonds with different interest rates and maturity dates, then buys the bonds at a discount to their offering prices—typically less than half a percentage point. The difference between the discounted price and what the underwriter sells them for is the underwriter’s pay. The underwriting process sets up an obvious conflict. The municipal issuer wants to pay the lowest possible interest rate. The underwriter wants to ensure the bonds will be attractive enough to easily resell to investors and bond dealers. The Municipal Securities Rulemaking Board, or MSRB, which writes rules for underwriters, requires them to disclose that they have “financial and other interests that differ from those of the issuer.”
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Many issuers engage advisers to help navigate the process and monitor the underwriters. Prairie-Hills Elementary School District 144, which serves pre-kindergartners through eighth-graders in Chicago’s economically struggling south suburbs, didn’t hire an adviser when it issued bonds in 2016. It needed money to add vestibules to school entrances so its staff could see and talk with visitors before buzzing them in, the superintendent said. An elementary-school roof needed to be replaced. School board members were eager to add air conditioning to classrooms. The district hired Oppenheimer & Co., which priced and sold about $20 million of municipal bonds on March 22, 2016. By the end of the first trading day, one-quarter of the bonds had been flipped, some of them back to Oppenheimer itself, according to the Journal’s analysis.
The Prairie-Hills school district near Chicago, which includes the Fieldcrest Elementary School, hired Oppenheimer & Co. to sell about $20 million of municipal bonds.
Oppenheimer, a unit of
bought back about $1.6 million in bonds it had sold to insurer Contintental Casualty Co. just hours earlier, then resold them for a profit of $10,969, NAIC and MSRB trading records show. Continental made $10,530. Trading in the first 10 days after the offering netted Oppenheimer and traders at other firms nearly $700,000, or about $540,000 when adjusted to account for movements in the broader market. Continental Casualty flipped bonds with underwriters 845 times between 2013 and 2017, the most of any insurer appearing in the Journal’s analysis. A spokesman declined to discuss those trades, saying by email: “We are not going to share any insights into this practice at this time.” The trading profits suggest the bonds were underpriced, meaning taxpayers will wind up spending additional money for interest payments. Oppenheimer said in written statements it had followed its standard protocol and is “confident that the pricing of the bonds was fair, reasonable and equitable to the district.” It said 2016 was a difficult financial year for Illinois and Cook County, and there was “significant uncertainty as to whether state aid would be available to fund the district’s budget.” The district’s bonds, however, were somewhat insulated from those concerns because they were insured, earning them a rating of AA by Standard & Poor’s, now S&P Global. Oppenheimer said that while it “sought buy-and-hold market participants, traditional buyers except for one, did not participate.” Last year, the Prairie-Hills district discussed issuing another bond to turn an old junior-high school into a building that could house a magnet school and alternative school programs. If the district decides to issue bonds, it will hire a municipal adviser, said Superintendent
The Journal’s analysis “is of intense interest and concern,” the superintendent said. “Districts pretty much depend on companies like Oppenheimer to be honest and do what’s in our best interest.” The MSRB, a self-regulatory organization overseen by the SEC, established the rule saying that underwriters have a duty to set “fair and reasonable” prices, but its rules also say the underwriter isn’t required to “exert its best efforts to obtain the ‘most favorable’ pricing” unless it tells the issuer it will do that. In an interview, MSRB senior adviser and former general counsel
said: “We have longstanding rules that require underwriters to treat issuers fairly and to purchase the bonds in an underwriting at a fair price.” He declined to comment on specific trades in the Journal’s analysis. In 2017, the Washington Economic Development Finance Authority sold $134 million of tax-exempt bonds on behalf of a private company building a facility that would convert farm waste to paper pulp. The company, Columbia Pulp I LLC, paid Goldman Sachs & Co. $3.8 million, or about 2.9% of the money raised, to underwrite the bonds. The unit of
Goldman Sachs Group
set prices so the bonds would generate annual interest of 7.75% for buyers—a high yield indicative of the speculative nature of the company’s new technology. Goldman sold the bonds in 25 trades, all at 11 a.m. on July 25, 2017. A little more than an hour later, some of the original buyers sold $10.75 million of the bonds to dealers at 5.3% more than they had just paid, generating profits of $571,000. Later that day, according to NAIC filings, Goldman bought back $6.6 million of bonds it had sold to insurers for $376,000 more than the buyers had paid. Trading records show Goldman then resold those bonds for a $42,000 profit. Within 10 trading days of the initial sale, $32 million of the bonds were flipped by initial buyers, the Journal analysis showed. Goldman and the dealers and customers who bought and resold them made market-adjusted profits totaling $2.2 million. Columbia Pulp declined to comment. In a written statement, the Economic Development Finance Authority said it “does not assume responsibility for or monitor secondary market trading in its bond issues.”
The post-offering buying and selling suggests bonds sold by the West Contra Costa school district, where John F. Kennedy High School is located, were initially underpriced.
Brian L. Frank for The Wall Street Journal
After the West Contra Costa bond offering in 2016, the underwriter, Piper Jaffray, said in a report to the school district that 23 financial firms and 16 smaller investors had bought $180 million of the $191 million in bonds. The report identified those firms as “going-away” buyers. The district’s financial adviser, Mr. Boehm, later told the school board: “The term ‘going away’ means that…these are true buyers. These are not dealers looking to just buy the bonds for purposes of putting [them] in the trading inventory.” A Piper Jaffray spokeswoman said the firm didn’t intend to give school officials the impression that the $180 million worth of bonds wouldn’t be resold. Write to Tom McGinty at firstname.lastname@example.org and Heather Gillers at email@example.com
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