Muni bond issuers: Disclosure? What disclosure?

The municipal bond market, already under a dark cloud due to rising risk levels, apparently has a pattern of lax financial reporting practices that could further elevate concerns about the market. A new study from DPC Data Inc. found that bond-issuing municipalities in general are delaying or ignoring their annual financial disclosure reporting requirements. In a sample analysis of 17,056 muni bonds, DPC found that 40% failed to meet self-reporting of financial disclosure requirements in 2009, the most recent fiscal year studied. That is up from 36% in 2008 and 33% during the period from 2005 through 2007. Of those municipalities that are submitting financial reports to the Municipal Securities Rulemaking Board's Electronic Municipal Market Access system, many are filing more than 180 days late. In fact, nearly three quarters of the studied bond offers either did not file required financial statements or filed so late that they were useless for credit analysis, according to DPC chief executive Peter Schmitt. “Our objective in this study was to find evidence of how easy or difficult it might be for investors to find timely information about municipal bonds they hold or are considering for purchase,” he said. “We were surprised to find so many issuers that file so long after the close of their fiscal years.” According to the report, which was released Thursday, 56% of muni bond issuers studied during the period from 2005 through 2009 were one or more years delinquent, and 19% failed to file any financial statements during any of those years. “The findings indicated that in any given year, it would be impossible to analyze credit risk or find any warning of default from officially filed disclosure data on significantly more than half the issues studied,” Mr. Schmitt said. “For people attempting to make good investment decisions or protect themselves from potential default, this is not good news.” The entire U.S. muni bond market includes approximately 80,000 potential issuers, of which 52,000 have issued municipal debt. And of that group, 26,000 municipalities are active in the market. The DPC's analysis of 17,056 muni bonds involved 10,185 municipal issuers. Until 1994, there was no law that required municipalities to make any financial disclosures to investors. The current disclosure rules are based on covenant agreements by the issuing municipalities that enable self-reporting to the MSRB. The federal government has no authority to require municipalities to file financial reports. The strongest reporting rule in place requires underwriting broker-dealer firms to require up-to-date financial reports, which is described by Mr. Schmitt as a “backdoor regulation.” It is estimated that two-thirds of muni bonds are owned either directly or indirectly through mutual funds by individual investors, which is something that Mr. Schmitt sees as a potential time bomb facing retail investors. However, at the institutional level, where there are more resources to conduct due diligence and alternative means to access financial statements from the municipalities, the situation is considered less dire. “We are dealing with the big creditors, like the state of New York, and it's in their interest to file on a timely basis,” said Sylvan Feldstein, a research analyst at RS Investment Management Co. LLC. While Mr. Schmitt acknowledged “no correlation between failure to file or late filing and the eventuality of default,” he balked at the suggestion that it is not a big problem, because only smaller issuers are in violation. “We've been listening forever to that ‘blame it on the little guy' argument,” he said. “We found no measurable relationship between bond issuer size and filing status.” Without the correlation between filing status and default rates, some in the muni bond space are suggesting that the delinquency rates are not a big deal. “One of the reasons you see late filings is that many muni issuers are small and do not have dedicated staff to manage the filings,” said J. Brent Burns, president of Asset Dedication LLC, which builds fixed-income separate accounts. The filing status “does not reflect the financial condition of the issuer so much as the [issuer's] lack of manpower,” Mr. Burns said. “As an investor, I'd rather see the issuer keep head count down and late-file than spend resources on staff to manage filings. In a perfect world, we'd have better transparency with timely filings, but there doesn't seem to be any evidence that not filing has any predictive power for determining credit quality.”