Using EMMA to Assess Municipal Bond Markups
Published in the PIABA Bar Journal, 20 (1): 99-122, 2013.
In the past, assessment of the reasonableness of municipal bond markups depended on anecdotal recollection of markups and subjective judgment about what was customary. Interested parties including regulators can now use the MSRB's EMMA service to determine the markups charged on a set of transactions and can make precise and accurate statements about how unusual such markups were, controlling for many factors thought to effect the reasonableness of markups.
We analyze over 13.7 million customer trades, totaling $3.9 trillion in par amount traded in fixed-coupon, long-term municipal bonds. We estimate that investors were charged $10.65 billion in municipal bond markups between 2005 and 2013 in our sample - $6.45 billion in trades on which excessive markups appear to have been charged.
Our sample includes about 30 percent of the fixed-coupon municipal bond trades and so the total markups charged from 2005 to 2013 is likely to be at least $20 billion. $10 billion of this $20 billion in markups were charged on trades on which excessive markups appear to have been charged. These markups are a transfer from taxpayers and investors to the brokerage industry and could be largely eliminated with simple, low-cost improvements in disclosure.
Oppenheimer Champion Income Fund
During the second half of 2008, Oppenheimer's Champion Income Fund lost 80% of its value - more than any other mutual fund in Morningstar's high-yield bond fund category. These extraordinary losses were due to the Fund's investments in credit default swaps (CDS) and total return swaps (TRS). The Fund used CDS and TRS to leverage up the Fund's exposure to corporate debt and asset-backed securities, including Mortgage-Backed Securities and swap contracts linked to Residential and Commercial Mortgage-Backed Securities indices.
What Does a Mutual Fund's Term Tell Investors?
Published in the Journal of Investing, Summer 2011, Vol. 20, No 2: pp. 50-57.
In a previous article, we highlighted a flaw in the average credit quality statistic frequently reported by bond mutual funds. That statistic understates the credit risk in bond portfolios if the portfolios contain bonds of disperse credit ratings. In this article we address a similar problem with bond mutual funds' reporting of the average term of their portfolios. The somewhat ambiguous nature of this statistic provides an opportunity for portfolio managers to significantly increase the funds' risks, credit risk in particular, by holding very long-term bonds while claiming to expose investors to only the risks of very short-term bonds.
Morningstar uses a fund-provided statistic - the average effective duration - to classify funds as ultra short, short, intermediate or long-term. Funds have figured out how to hold long-term bond portfolios yet be classified as ultra short-term and short-term bond funds. We show that extraordinary losses suffered by these funds in 2008 can be explained by the how much the bond funds' unadulterated weighted average maturity exceeded the maturities typically expected in short-term bond funds.
What Does a Mutual Fund's Average Credit Quality Tell Investors?
Published in the Journal of Investing, Winter 2010, Vol. 19, No. 4: pp. 58-65.
The SLCG study explains that the Average Credit Quality statistic as typically calculated by the mutual fund companies and by Morningstar significantly overstates bond mutual funds' true credit quality. This statistic is based on Standard & Poor's and Moody's assessment of the credit risk of the individual bonds in the portfolio and is reported to mutual fund investors using the familiar letter scale for rating the credit risk of bonds.
The study concludes that, for instance, funds that have the credit risk of a portfolio of BBB-rated bonds often report an Average Credit Quality of A or even AA and that given how this statistic is calculated, portfolio managers can easily manipulate their holdings to significantly increase their credit risk and thereby their yield without increasing their reported credit risk at all. Since bond fund managers compete for investors based on yield and risk, the authors find that fund managers who report Average Credit Quality have the ability and the incentive to increase but underreport the credit risk in their bond mutual fund portfolios.
Charles Schwab YieldPlus Risk
From June 2007 through June 2008, investors in YieldPlus (SWYSX and SWYPX) lost 31.7% when other ultra short bond funds had little or no losses. Schwab had marketed YieldPlus as a low risk, higher yielding alternative to money market funds.
The report concludes that YieldPlus's extraordinary losses occurred because the fund held much larger amounts of securities backed by private-label mortgages than other ultra short bond funds. In doing so, Schwab's fund violated concentration and illiquidity limits stated in its prospectus. These private-label mortgage-backed securities holdings had given YieldPlus a slight advantage over its peers prior to 2007. Unfortunately, the extra yield was an order of magnitude smaller than the losses that followed when the value of structured finance securities - especially those backed by mortgages - dropped significantly.
SLCG also found that Schwab significantly inflated the value of YieldPlus's holdings and therefore its NAV in late 2007 and early 2008. By inflating the YieldPlus fund's NAV, Schwab provided existing investors incorrect information about the value of their investments and caused new investors to overpay for shares in YieldPlus.
Regions Morgan Keegan: The Abuse of Structured Finance
Investors in six Regions Morgan Keegan (RMK) bond funds lost $2 billion in 2007. The RMK funds held concentrated holdings of low-priority tranches in structured finance deals backed by risky debt. We provide five examples of the asset-backed securities RMK invested in: IndyMac 2005-C, Kodiak CDO 2006-I, Webster CDO I, Preferred Term Securities XXIII, and Eirles Two Ltd 263.
RMK did not disclose the risks it was taking until after the losses had occurred. In fact, RMK misrepresented hundreds of millions of dollars of highly leveraged asset-backed securities as corporate bonds and preferred stocks thereby making the funds seem more diversified and less risky than they were. RMK and Morgan Keegan also materially misled investors by comparing these funds to indexes which only contained corporate bonds despite the fact the RMK fund held three times as much asset backed securities as they held corporate bonds.
The RMK funds held roughly 2/3rds of their portfolios as of March 31, 2007 in structured finance securities and only 22% or 23% in corporate bonds. RMK's structured finance holdings were roughly 90% in mezzanine and subordinated tranches and only 10% in senior tranches. The vast majority of tranches by market value are classified as 'senior' and so the RMK funds were overwhelming invested in the bottom of structured finance deals'capital structures. The attached Excel file contains SLCG's classification of securities in the RMK by senior versus mezzanine/subordinated.
Download SLCG's Classification
Roughly 90% of the losses suffered by the RMK funds identifiable from their public filings during the last three quarters of 2007 when the funds collapsed were from the funds' holdings of structured finance securities. The attached slides summarize SLCG's classification of losses in the RMK funds in the last three quarters of 2007.
Download the RMK Losses Due to Structured Finance and Internally Priced Securities slide
Download the RMK Losses Due to Structured Finance and Internally Priced Securities backup
Mutual Fund Share Classes and Conflicts of Interest between Brokers and Investors
Dr. O'Neal describes the various mutual fund share classes and explains how differences in commissions to brokers and costs to investors across share classes can create conflicts of interests.