Oct. 21 (Bloomberg) -- If your state or locality could sell its bonds directly to investors, it would save a lot of money.

This is the conclusion of an academic research paper now finding its way to the in-boxes of government finance officers.

How does it work now? Wall Street puts bonds in inventory and marks them up to sell to individual investors.

Or they sell big blocks of bonds to institutional investors -- hedge funds, mutual funds and the like -- who then ``flip'' them out at a higher price to the smaller brokers who sell to individuals.

``Our results suggest both issuers and investors could benefit from mechanisms that give retail investors more direct, low-cost access to the primary bond market through participation in the offering,'' says the paper.

It also says: ``Broker-dealers and large institutions in the market seem unlikely to support the development of such mechanisms, since this will eliminate what appears to be an important, and relatively opaque, source of profits to them.''

The municipal market doesn't respond well to scrutiny, or questions, or criticism. This is the way we do it, bankers and traders say, and it's right, because that's the way it's done.

`Flipping' Bonds

The paper is called, ``Dealer Intermediation and Price Behavior in the Aftermarket for New Bond Issues,'' and is the work of Richard C. Green and Burton Hollifield of Carnegie Mellon University's Tepper School of Business, and Norman Schurhoff of the University of Lausanne.

This is a dense work, its pages filled with statistics and Greek-letter formulas. It is important because this seems to be the first public acknowledgement of something that observers of the market have long known -- that some big investors are able to make money by simply acting as conduits.

``Flipping'' is a word associated with initial public offerings in the stock market, not the municipal market. You've heard all the stories. Certain favored investors are given the opportunity to buy stock at its initial offering price, and then rack up big profits as the stock's price doubles or triples when it goes public.

Routinely Mispriced

How it works in the bond market is a little different. Let's say a bond with a 5 percent coupon due in 20 years is priced at 100, to yield 5 percent.

A big mutual fund manager gets a block of these bonds at 100. He sells them a week later at a price of 102, which has the effect of lowering the yield on those bonds to 4.84 percent. As a taxpayer, you have to ask, Gee, wouldn't it have been better to borrow at 4.84 percent rather than 5 percent?

Of course it would have. A municipality that borrows $1 million at 5 percent pays back $2 million: $1 million in principal, and $1 million in interest. A municipality that borrows the same amount at 4.84 percent pays back $1 million in principal, and $968,000 in interest.

The authors of this study even refer to ``flipping'' by name. ``The flipper takes a large block of bonds from the underwriters, and then resells the bonds to dealers such as regional brokerage firms with retail sales networks.''

If this is true -- if bond issues are routinely mispriced this way -- then it flies in the face of everything bankers have been telling issuers about the beauty and wonders of selling bonds through negotiation for years, although the authors don't address the negotiated versus competitive question.

The Promise

Once upon a time, almost all bonds were sold at auction. Underwriters bid for bonds, and won them with the best price. There was another way of selling bonds, called negotiation, where issuers decide who wins the bonds first, and then negotiate the terms. That was only used for big, unusual, new or profoundly dysfunctional credits.

What happened in the 1970s was this: Bankers started telling issuers that they could not only sell their weird or bad or big bonds -- they could sell all their bonds better through negotiation. Just, they said, award us the bonds and we will get the best price for them, and get them into the hands of the final buyers, and get wide distribution for you, and on and on.

Issuers bought it. Now more than 80 percent of the municipal market is sold through exclusive dealings with underwriters. Underwriters liken negotiation to buying a bespoke suit rather than one off the rack. Issuers like the full service.

What happened? It appears that at some point negotiation stopped being about bespoke, and about getting the bonds out the door. Are issuers getting the best price? Or are they getting the easiest price? Do they care?

Questions to Ask

``Dealer Intermediation and Price Behavior'' isn't a fool- proof, conclusive piece of work. For one thing, it is based on 1,000 deals done from February 2000 to July 2003, out of perhaps 30,000 that were sold.

For another thing, the report is based on data provided by PriMuni, a Pittsburgh company that since 2003 has been trying to sell the market on a system of differential pricing, using its software. This is one of those ``mechanisms'' the authors refer to in their report as offering retail investors low-cost access to the primary market. It would seem to be in PriMuni's best interest to select transactions that were mispriced.

Finally, the market is more transparent than it was from 2000 to 2003 -- dealers have had to report all trades within 15 minutes of their occurrence since Jan. 31. In theory, this means that individual buyers have information about where bonds should be trading, and should be less willing to accept the 4.84 percent instead of 5 percent.

Government finance officers have to ask two questions. First: Is this really the way it works? Second: If I'm paying someone to underwrite my bonds, why do I also have to pay a hedge fund to distribute them?

To contact the writer of this column: Joe Mysak in New York at Or jmysakjr@bloomberg.net.

Last Updated: October 21, 2005 00:03 EDT