We thank our clients and others who count on us and wish everyone a healthy and prosperous 2015. This past November marked the beginning of our thirtieth year in business. Today, I want to share a few thoughts with you, some of which I’ve been reflecting on for a long time.
The municipal bond market was much different when we began in 1984. Today, our business model does not resemble our model in 1984, but our core values remain unchanged:
- Municipal bond specialization – Remain experts in our area of the bond market through in-depth research, continuing education and plain hard work
- Excelling at core market competencies – Excel at the core functions of municipal bond specialization: municipal bond credit research, portfolio management, public finance, trading and underwriting
- Honest client service – Serve our clients honestly and forthrightly
- Clear communication – Maintain timely and clear communication with our clients
- Above average performance – Constantly endeavor to achieve above average performance for our clients
- Principal oversight – Firm principals engaged in daily business operations
- Consistent employee commitment – Ensure each and every employee of Bernardi Securities understands and conducts business in a manner consistent with these values
Common sense tells us if we focus our energies on these values, work hard, treat people fairly, push ourselves to evolve and improve, then our clients will prosper by interacting with us. We believe our success will follow.
This is what has occurred over nearly three decades. We started as a small organization of four people. Over three decades our team, talents and responsibilities have grown. Our role has developed into something significant: across the country, thousands of people, their families, dozens of communities and financial institutions rely on us to help improve their lives and organizations.
I thank our clients for your confidence and support over the years. From the outset, we were fortunate to have loyal people who believed in us. Everyone at Bernardi greatly appreciates and values this honor.
In Italian, there is a phrase “grazie mille.” Familiarly it means, “thank you, very much.” Literally, the phrase means “ thank you, one thousand times.”
Grazie mille, to all of you who count on us and all those who have helped us over the years.
The idea of forming Bernardi Securities, Inc. belongs to our Chairman Edward Bernardi. Ed is my father and has been involved in the municipal bond business for over 50 years. He led and taught us for years. He urged us to remember our principles, believe in ourselves, work hard and treat people fairly. He taught us what we needed to know about running a business, teaching both the formal and informal lessons: lessons we needed to learn in order to help our clients and our firm prosper. He was masterful, a great communicator. There were many, mostly small, moments in time when he taught us. And over many years, the sum of these moments has brought our organization to the place where we find ourselves today. Thank you, Ed.
COOL HAND LUKE SYNDROME
We have noticed over the years that market participants, including ourselves, sometimes suffer from the Cool Hand Luke syndrome — “a failure to communicate.”
Poor or inadequate communication inevitably leads to mistaken and inaccurate impressions. It allows the actions of a few to taint the market’s perception of the many. The municipal bond industry suffers a bit from this.
The press has focused its attention on the municipal bond market in recent months.
Some of the reporting is accurate and some of it is oversimplified storytelling.
Our family has been active in the municipal bond market for over 50 years. We can attest that it is a complicated place. Sometimes municipal bonds are hard to understand. These are two reasons we decided to specialize in this market. Often, people who sell them do not understand what they are buying or selling.
This market update discusses several problematic issues facing the industry. It addresses how the market generally operates and how Bernardi operates and navigates through it. It offers our perspective on these issues and describes some of our policies and best practice procedures. We have put these in place to better ensure we interact with our clients effectively, efficiently and fairly.
MUNICIPAL BONDS BUILD AMERICA – A CHANGING MARKET NEEDS TO ADAPT
The municipal bond market has been one of our nation’s greatest growth engines for over 100 years. It is a $3.7 trillion market with new issuance surpassing $330 billion in 2014. Our public finance market is envied around the world for its ability to raise capital efficiently and independently of the federal government. In a typical year, approximately 70% of our country’s public infrastructure is financed by municipal bonds.
All of that said, it needs to improve in many ways and here’s why — the state of a nation’s infrastructure greatly determines its future, so a healthy and effective municipal market is critical to our country’s future prosperity.
The demand side of the municipal bond market has shifted in recent years. Today, municipal issuers are more dependent than in the past on individual investors and community banks. Many hedge funds and insurance companies have reduced the size of their municipal bond portfolios in recent years. Some are no longer active buyers. The Federal Reserve’s September ruling that excludes municipal bonds that can be held by large banking institutions from the list of high-quality liquid assets may reduce future demand for municipals from some of these institutions. Additionally, the number of dealers supporting the market has shrunk. Some broker-dealers and dealer banks are committing less capital to their municipal business than they allocated pre-2008 because their business model is under considerable stress. Dealers act as buffers absorbing bonds investors want to sell and holding them in inventory until an appropriate buyer is found. These changes have affected market liquidity.
It is important that creative solutions emerge to address the marketplace’s issues. Public officials representing municipal bond issuers, investors and their advisors need to have confidence in the market’s integrity of information and its fairness. There are changes that can be put in place to improve the marketplace.
Lastly, leaders need to position themselves at the vanguard of change. We intend to continue to be part of this change.
So what are the issues of the day?
COST, TRANSPARENCY & DISCLOSURE — THE MUNI MARKET’S TRIPLE HORROR SHOW?
“Muni Bond Costs Hit Investors in Wallet” – The Wall Street Journal, 3/10/2014
“SEC’s Piwowar Wants Simpler Muni Bond Transactions” – The Bond Buyer, 8/1/2014
“SEC cracks down on disclosure in municipal bond sales” – The Washington Post, 6/28/2013
“Munis Beating All Debt Shows Faith in Local Government” – Bloomberg News, 11/4/2014
“Munis Are Talk of the Town-high returns this year outpace those of blue chip stocks, corporate debt” – The Wall Street Journal, 11/3/2014
“Investors Flock to Municipal-Bond Market” – The Wall Street Journal, 12/29/2014
If Edgar Allen Poe had ever written a tale about the municipal bond market and based it solely on the top three headline stories, the work would have been a bone chilling horror story.
The last three headlines underscore the market’s paradoxical nature. Today, there is a lot of confusion and misunderstanding about the municipal bond market. In the coming pages we share our perspective.
The municipal bond market is vast. There are over 50,000 distinct issuers, more than one million municipal bond issues outstanding. The market is well developed and generally efficient given the number of issuers. It is diverse, fragmented and nuanced because there are so many issuers.
Generalizing about municipal bonds makes for a risky business. Each municipal bond, each sector has unique characteristics, criteria and risks. It is not a homogeneous marketplace. Which is a major reason the market did not implode during the 2008-2009 financial crisis — unlike the commoditized mortgage market. This characteristic is a bedrock of its strength and a primary reason conservative investors find it an attractive place to invest.
The diversity and lack of homogeneity in the municipal bond market create some of its most vexing issues. Herein lies the cause of the market’s paradoxical nature. Different borrowers have differing needs and views as to how best repay their loans. Different investors have different needs. Loans are customized to suit these differing needs.
Therefore, creating market scalability is difficult and, arguably, undesirable to some market participants. It is an intrinsically, fragmented market. Fragmentation affects cost and liquidity.
The market’s lack of homogeneity is both a strength and a weakness. A conundrum perhaps — but not a bad or troublesome issue in our view. The market is much improved from 5-10 years ago. Additional improvements are needed, are occurring and will continue.
REGULATORY OVERSIGHT OF THE MARKET IS SIGNIFICANT
The municipal bond market is highly regulated. Generally, it is orderly and fair. Investors and issuers enjoy great protections provided by regulatory authorities and many responsible firms serving the marketplace.
Bernardi Securities takes great pride in its exemplary regulatory record. We have experienced first-hand, for over 30 years, regulators from the SEC, FINRA and state agencies routinely examine, audit and visit our offices. These exams ensure our policies and procedures adhere to the many rules we are required to follow. These exams are thorough.
Investors clearly want more regulatory protection and, per a recent FINRA study, appear willing to pay for some of it. In November, FINRA released a study with findings showing 92% of investors say it’s important to have a “cop on the beat” to protect them, 74% support “additional regulatory protections” and more than half (56%) favor enhanced regulation even if it results in “a minimal increase” in costs. It is likely regulatory oversight and investors’ costs will increase in the coming years.
Some market critics feel regulatory agencies have not focused sufficient attention on the municipal bond market; some even claim it has been ignored. We disagree.
The market is not broken and it is not static. Improvements to market structure are never finished. The SEC has ramped up its enforcement capabilities in recent years and has become much more effective in protecting investors and issuers. Likewise, FINRA, our industry self-regulator, has clearly raised the bar for broker-dealer conduct. It has strengthened the suitability rule and has provided clear guidance on mitigating or avoiding conflicts of interest. There are numerous recent examples of how modern technological resources enhance the data regulators, issuers and investors receive and analyze about the municipal bond market.
Here is a sample of established rules governing independent municipal advisors and broker-dealers, as well as a few recent regulatory and industry led initiatives. The scope of these rules demonstrates that regulators and market participants are leading the market to a heightened level of transparency and disclosure. This results in improved information flow and lowers investor and issuer costs.
We follow each rule with a brief explanation of our internal policy related to it. Our policies are designed to produce results exceeding what is required by the rule.
1. Municipal Securities Rulemaking Board (MSRB) Rule G-19 – the rule requires a broker-dealer to have a reasonable basis to believe a recommended transaction or investment strategy involving a municipal security is suitable for a customer. Suitability is determined through information obtained through reasonable diligence of an investor’s investment profile.
Here are two Bernardi policies designed to ensure our behavior surpasses what Rule G-19 requires. Since our inception, we have been bearish on passive bond investing and bullish on credit analysis. We manage our clients’ mattress money so our municipal bond portfolio research and management process starts with credit research.
Firstly, all municipal bonds bought by our firm are approved by the Bernardi Credit Committee. The only exceptions to this rule occur when a client instructs us to purchase a particular issue for them. If the credit is not on our approved list, we inform them of that fact and execute the trade on an unsolicited basis.
The committee adheres to a time tested process. This process has been honed over many years and numerous market cycles. It is time consuming and granular to its core. It has served our clients very well especially during and in the aftermath of the 2008-2009 financial crisis.
We meet many times during the course of a typical week discussing and reviewing the current state of credits brought to our attention by our credit research department. The outcome of these meetings varies — credits are added to the list, some are removed and others are placed on a heightened watch status. The result of this work is important to our clients — only credits approved by the committee are offered to them for investment.
Secondly, our policies and procedures require that all of our portfolio-managed clients complete a Letter of Understanding and Investor Profile document before any investment program commences. Periodically, the documents are reviewed and amended, if the situation warrants. The client is assisted in this process by our investment specialists and portfolio managers.
Similarly, our policies and procedures require non-managed accounts to complete a Bond Offering Profile (BOP).
Adhering to these disciplines better ensures our recommendations are consistent with client needs and objectives, ensuring our compliance with the rule.
2. MSRB Rule G-30/FINRA rule 2111 – these rules require dealers to purchase and sell municipal securities for its own account to customers at a price that is fair and reasonable given the prevailing market conditions.
This is a governing rule that helps determine how we price bonds we offer to our investor clients.
Trading of municipal bonds is highly decentralized and the process for selling bonds is very different from selling stocks. There is no central exchange to look at in order to determine the price of a particular security and rarely are there numerous buyers and sellers of a given municipal bond (same cusip) over a short time span. The MSRB 2013 Fact Book points out that on average, an individual municipal security trades less than 3 times per day. Since new issue securities often trade multiple times a day, the ordinary trade frequency of secondary market securities is even lower. There are over 1.5 million unique municipal bonds outstanding versus approximately 5400 corporate issuers.
This reality makes bidding and pricing municipal bonds an inherently more subjective exercise. This is a reality of the municipal bond market. It behaves differently than the commoditized U. S. Treasury bond market. Perhaps one day, multiple standardized electronic trading protocols will change this dynamic, but that day will not arrive until municipal bond offerings are simplified and standardized. Simplification will require excluding features like sinking fund call dates and special redemption features. Standardization will require, perhaps, a “one size fit all” call feature or complete lack of a call option altogether.
Generally, these changes will improve market liquidity, but will come at a cost for issuers: reduced choices and flexibility. If standardization occurs, it will require the market to move away from its current issuer centric focus to a more investor centric focus. This change will prove problematical for some issuers, especially small, less frequent issuers.
Clearly, investors need help with pricing disclosure in spite of great improvements in this area in recent years. Today, there is significant trade and transaction data available to retail investors. Price information flow to investors has improved greatly and advancements will continue in this area.
Firstly, in 2000, the MSRB began making public all trade data available on a one day delay. In 2009 the MSRB created an investor website called EMMA (Electronic Municipal Market Access). EMMA provides access to official statements, market statistics and a price discovery system. Information is provided at no cost to the public and is helpful to investor’s and market participants. Its introduction and subsequent improvements have greatly improved pricing discovery and disclosure in the municipal bond market.
Secondly, technological innovation continues to yield additional information and efficiencies to investors. Some standardization will be incorporated into the disparate new issue market in the future. This will help improve both market liquidity and reduce costs.
At Bernardi we have a thorough, multi-step process to ensure fair and transparent pricing. We have built checks and balances into our pricing and bidding procedures in order to minimize pricing subjectivity affecting our investor clients. We compare a bond’s price to benchmarks and comparable issues recently traded. We check to see if the particular cusip has traded in recent days. Market volatility at the time of pricing may also affect a pricing decision. Our procedures coupled with Rule G-30 guide how we price bonds. They have evolved over the years and our stringent adherence to them help ensure our compliance with the rule.
Investor costs, of course, are related to fair pricing and are a critical determinant to performance. Years ago, we developed two pricing models in order to help clients assess the reasonableness of our compensation. Both models provide portfolio-managed clients pricing transparency and a reasonable cost structure. We offer two options because investors have different needs.
Too often, we see people with a tendency to look at the cost issue as a black versus white issue — commissions are good, fees are bad or commissions are evil, fees are good. In reality, one option is often more economical for one person and less economical for another. A fee-only option is suitable for a particular portfolio and in other cases a non-fee option is appropriate. That is why we offer two pricing options:
- Fee-only option through Bernardi Asset Management (BAM). BAM was formed in February of 2000 at the request of clients who wanted this type of management. BAM is a wholly owned subsidiary of Bernardi Securities, Inc. (BSI). BSI is a licensed broker-dealer regulated by the SEC, FINRA, various state agencies and subject to rules written by the MSRB. BAM is a SEC registered investment advisor serving as a fiduciary and managing bond portfolios on a fee only basis. There are no mark-ups/mark-downs under BAM management; bonds are placed in portfolios at the same price as BSI buys from the selling party. There is a nominal trade ticket charge.
- Non-fee option through BSI. Clients are charged on each transaction through a mark-up or mark down rather than paying an annual management fee. If there are no transactions, the portfolio incurs no costs. The BSI portfolio management process captures the mark-up/mark down of each transaction. Portfolio managed clients are welcome and entitled to know the exact mark-up or mark-down of a particular transaction. Some clients request we include this information as part of their year-end portfolio management report. Some request the information more frequently and many do not request it at all. We instituted this open book policy for managed portfolio clients more than ten years ago in order to promote transparency.
The net effect of MSRB rule G-30 coupled with our policies and procedures provides our clients with cost effective and transparent order execution and is another example of how our best practice policies go beyond what the rule requires. These policies work well for our clients and our organization.
3. Municipal Advisor Rule, effective date July 2014 – the rule regulates previously unregulated independent municipal advisors (IMA) interacting with issuers and exists to protect issuers. The rule clearly defines differing roles of IMA and underwriters. It also limits an underwriter’s interaction with issuers absent an exemption.
Bernardi serves only as an underwriter and does not serve as a municipal advisor. We’ve made significant revisions to our operating procedures to comply with the rule after dozens of hours of internal meetings and in consultation with regulatory agencies and our counsel. As a result of the rule, our bankers clearly communicate to issuer officials, verbally and in writing, at the earliest moment of a potential transaction, our role, responsibilities and all other required disclosures. We provide only general information and hypothetical borrowing cost and potential refinancing savings absent an exemption.
Naturally, many issuer clients seek our advice and recommendations once we are engaged.
The net effect of the rule improves transparency and disclosure in the market and better protects issuers, taxpayers and system users from poor performing municipal advisors and underwriters.
4. MSRB Rule G -18 – the SEC recently approved the MSRB’s proposal to require municipal bond dealers to seek the most favorable price possible when executing transactions for investors. The “best–execution” rule is effective December 2015.
The rule does not require the dealer to always achieve the absolute best price in spite of the rule’s label.
The rule establishes an explicit obligation for dealers to use reasonable diligence when handling and executing municipal security trades for retail investors. The rule’s goal is to achieve as favorable a price as possible under prevailing market conditions and requires dealers to have a process to evaluate all reasonable venues to trade a customer’s bond and execute at the best price the process reveals. This proposed rule would replace the current “fair pricing” standard which requires a dealer to know the market value of a security and use diligence in the attempt to ascertain it.
At Bernardi we have long had in place an execution diligence process and feel strongly our process operates fairly and efficiently on behalf of our clients. Our process consistently delivers an execution level far above what current rules require.
Strengthening the execution standard will provide investors with additional protections by requiring all dealers to diligently search for the best price for a customer.
5. The MSRB has requested comment on whether it should require dealers to disclose its price or a mark-up as a way to improve market transparency. The proposal is an attempt to address concerns about hidden mark-ups in so called “riskless principal transactions.” The proposed rule would require a dealer to disclose to its customer what the dealer paid for the security on the same day for all transactions of $100,000.00 or less.
Arriving at consensus definition of “riskless principal transaction” is major point of disagreement. The proposal is currently in its comment phase. We recently submitted a comment letter to the MSRB.
6. SEC Rule 15c2-12 – the SEC is currently soliciting comments on improving disclosures and regulatory burdens of Rule 15c2-12. It is seeking ways to enhance the quality and clarity of information disseminated pursuant to the rule. Written comments are due by January 20, 2015.
Rule 15c2-12 requires underwriters of municipal securities perform numerous activities and is intended to enhance disclosure in the municipal securities market, thereby reducing issuer fraud. Here is a summary of a few of the rule’s requirements of underwriters:
- Review an official statement deemed near final by the issuer of securities before making a bid to purchase, offer or sell a municipal security
- In non-competitively bid offerings, to send, upon request, a copy of the most recent preliminary official statement (if one exists) to potential customers
- To contract with the issuer to receive, within a specified time, sufficient copies of the final official statement to comply with the rule’s delivery requirement
- Before purchasing or selling municipal securities in connection with an offering, to reasonably determine if the issuer or the obligated person has undertaken, in a written agreement or contract, for the benefit of holders of such securities, to provide certain information on a continuing basis to the MSRB in an electronic format as prescribed by the MSRB. The information to be provided includes, but is not limited to: annual financial statements, operating information, notices of the occurrence of any of 14 specific events, notices of the failure of an issuer or obligated person to make a submission required by a continuing disclosure agreement.
The SEC released a report recently estimating that approximately 20,000 issuers, 250 broker-dealers and the MSRB will spend 115,248 hours per year complying with Rule 15c2-12. The report estimates issuers will submit approximately 62,596 annual filings to the MSRB in 2014 requiring an estimated 46,947 hours to prepare and submit these filings. Annualizing data received through September, issuer event notice filings will exceed 73,000 in 2014.
The requirements of Rule 15c2-12 are substantial on both issuers and underwriters.
This past year, underwriters, issuers and their advisors spent thousands of hours responding to and attempting to comply with the SEC’s Municipalities Continuing Disclosure Cooperation Initiative (MCDC). MCDC was announced on March 10, 2014. This program provided issuers, their advisors and underwriters the opportunity to self-report non-compliance with continuing disclosure undertakings on prior issuances. The broker-dealer deadline to self- report was September 10th while issuers had until early December to report. It remains unclear at this time as to the scope of any SEC enforcement actions resulting from the initiative.
We’ve spent dozens of hours reviewing underwriting transactions going back 10 years analyzing files on hundreds of transactions. Our review was exhaustive. We uncovered a number of instances where, in our opinion, issuers failed to comply with their continuing disclosure undertakings. We informed those issuers, their counsels and, if applicable, their advisors of our findings. It was then up to each issuer to decide whether it agreed with our opinion and, if so, to report itself to the SEC as we had done.
Disclosure in the municipal bond market has improved significantly in recent years. The gaping holes in disclosure that were prevalent a decade ago have mostly disappeared, but current disclosure efforts need continual improvement.
This is one of the most important issues facing the municipal bond market, in our view. The MCDC initiative has clearly gotten the attention of most market participants. Many issuers, their advisors and counsels who prior to the program did not focus on the rule, are now focused on adhering to its requirements. Responsible underwriters will undoubtedly remind them of their requirements, if that is needed.
At Bernardi, our credit research and underwriting process’ were amended and improved in 2012 shortly after the SEC’s 2012 regulatory alert. They now include a more thorough review of an issuer’s disclosure practices. Rules protecting investors, in effect, necessitate us policing the issuer’s official statement, a document prepared by an issuer, its counsel and advisor. This takes a lot of time and careful analysis. We complete this process several dozen times in a busy trading week.
The Bernardi credit committee views a non-disclosing issuer or an issuer that files late differently from one that files timely, complete and accurate disclosures. Our tolerance level for late or improper disclosures is different than it was in the past. This is not to say we universally avoid trading the bonds of late filers. It depends greatly on the issuer’s circumstances and history. We discuss specific circumstances at length in credit committee meetings.
Additionally in many instances, we remind issuers of their continuing disclosure requirements in order to help ensure timely and accurate filings. This internal procedure of ours helps improve market disclosure practices, we believe.
There are a lot of rules related to operating in the municipal bond market. Adhering to the requirements of 15c2-12 serves as a very good example of how trading municipal bonds is much more complicated than trading U.S. Treasury bonds or equities.
HONEST CLIENT SERVICE & CLEAR COMMUNICATION
Clearly, rules and regulations are needed and participants in the municipal bond market are subject to many. Perhaps layers of regulation are a necessity in today’s complex marketplace, but in the end we believe a fundamental relationship dictum tells us our dealings with clients rely greatly on trust. We expressed this in our third and fourth core values at the beginning of this letter:
- Honest client service – Serve our clients honestly and forthrightly
- Clear communication – Maintain timely and clear communication with our clients
Our core values define our organization and the principles of an ethical business culture. They are at the core of our company’s daily actions. For nearly 30 years, these statements have served as the central tenet of our operating philosophy. We strive to reinforce this belief with policies and processes that reward ethical behavior. This approach has worked well for our clients and us for decades.
Successful, vibrant organizations are replete with potential conflicts. Everyone in a successful business encounters a potential conflict or two. This is not bad in and of itself.
It is how one deals with those conflicts that matters.
We have expended great effort over the past 30 years searching for, finding and eventually doing things a better way. It was often difficult, often less profitable and sometimes uncomfortable. But once we start doing something a better way, it really does not matter what the old way was; we know we have moved onto something our clients want and that makes it and us even more relevant.
Rest assured we are not going backwards. We are looking forward to the next 30 years. We hope you are with us along the way.
Thank you for your continued confidence and support.
Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.