In early April, Pyrolyx USA Indiana LLC, a tire recycling plant based in Terre Haute, IN, became one of the first companies to report a bond default tied to the COVID-19 health crisis.
The company announced on 6 April that it was closing its two facilities in Indiana and Germany and would not be able to make loan payments to Terre Haute, which back USD 31m of economic development solid waste facilities revenue bonds that the city issued in 2017.
Despite the default and a recent audit that raises questions about the company’s ability to continue as a going concern, the bonds have not lost value on paper. Their trading price is marked at 100 based on the most recent trade, from June 2017, according to Electronic Municipal Market Access (EMMA).
The bonds have also not suffered a decline in evaluation data posted by Refinitiv. The bonds have been valued at a price of 98 or 99 since early April, before the default announcement. As of 14 May, the bonds were evaluated at a price of 99 with a yield of 8.9%, according to information provided by Interactive Data on Refinitiv’s website.
Interactive Data, which was acquired by Intercontinental Exchange, Inc. (ICE) in late 2015, is one of four pricing service providers relied on by the muni market. The others are Refinitiv, IHS Markit and Bloomberg’s BVAL.
Accurately valuing the bonds -- a job that rests largely with the pricing services -- is crucial for establishing mutual fund net asset values (NAVs) and for retail investors who want to know what their bond is worth.
The challenge has worsened since the pandemic, which has wrought both a market liquidity freeze and credit deterioration, according to several market participants. The importance of transparent pricing is more important than ever, sources said.
“High yield is a much harder market for pricing services to price, and it’s as liquid as mud,” said a Midwest-based municipal fund portfolio manager.
Most sources said they expect a wave of defaults to hit the high-yield space, and that the space has yet to hit bottom. Yet many high-yield bonds continue to show relatively high valuations, even as the sector struggles to find buyers.
“When the big selloff happened in March, the big high-yield portfolios lost a lot of money very quickly,” with some funds losing 20% in 15 days, said a portfolio manager. “But they did an excellent job of not trading stuff that’s truly, truly junk and by not opening that up to the market, they didn’t allow price discovery to happen.”
That means some high-yield portfolios are inflated, the manager said. Investors are buying “at a level that isn’t real and that’s a little scary to me. There’s a whole bunch of these things out there being carried at levels that almost certainly are not reflective of the true value,” the manager said. Pricing discovery companies are “in a very, very difficult spot because there’s no way to put a correct value on it.”
IHS Markit uses multiple data sources to evaluate bonds, Tozar Gandhi, associate director in municipal bond pricing at IHS Markit, said. That includes the new issue market, trades published on EMMA and quotes distributed between dealers and other market participants captured by its data parsing engine.
“For high-yield bonds we also stress a lot [of] credit analysis, especially in sectors where we think we need to dig into more detail and analyze financial statements, etc.,” Gandhi said, adding that IHS Markit also speaks regularly to buy-side shops regarding what they see in the market.
While clients sometimes challenge evaluations, “we definitely maintain independence on our side when evaluating prices,” he said.
IHS Markit also publishes a liquidity score along with its prices for its clients, Gandhi said.
“Every bond is given a liquidity score from … one to five, one being the most liquid and five being the most illiquid,” he said.
Pricing services have developed “fantastic” methodologies for evaluating investment-grade municipal bonds, a former high-yield trader familiar with pricing methodology said. But increasingly, at the behest of some – though far from all -- mutual funds, pricing services are being asked to apply investment-grade pricing methodology to more and more of the high-yield municipal market, a much less liquid animal, the person said.
“Fiduciary responsibility requires more. Much more,” the former trader said, citing the potential negative impact on high-yield municipal bond mutual fund holders. “These bonds are much more illiquid than investment-grade securities.”
The Municipal Securities Rulemaking Board (MSRB) does not have a stated policy on price evaluation of municipal securities, MSRB spokesperson Leah Szarek said in an email to Debtwire last week. However, MSRB rules related to best execution and prevailing market price do reference the use of price evaluation, she said.
“Specifically, guidance on confirmation disclosure and prevailing market price states that while dealers can use a third-party evaluated pricing service, the dealer should have a reasonable basis for believing the third-party pricing service’s pricing methodologies produce evaluated prices that reflect actual prevailing market prices,” Szarek said.
The MSRB regulates dealers, not pricing services or mutual funds, she said, “so the pricing obligations under our rules only apply to dealers.”
The US Securities and Exchange Commission, which regulates mutual funds, declined to comment on whether it has a stated policy regarding price evaluation of municipal bonds held by mutual funds.
For a pricing services, their independence from the clients who pay them is key, said JR Rieger, owner of the Rieger Report LLC, who previously worked in S&P’s pricing and index services. “The pricing agencies should always act independently of their clients but there’s an inherent conflict of interest in that they’re paid by the client,” Rieger said. “The independence and reputation of the pricing services is something that has to be held above all in their process.”
Pricing services faced with a bond that hasn’t traded recently will usually rely on a comparable bond to evaluate the price, Rieger said. But in the high-yield sector, the credits are highly unique and can’t be compared, said Rieger, adding the services should be digging into actual versus projected cash flow and other nuances of each project.
“It’s a bigger job on the high yield side than just looking at the trades,” he said. “A lot of high yield bonds do not trade frequently, and the independence of the evaluator is very critical here. They need to make some determinations that the bonds are the same or different since last time they’ve traded.”
Fund managers who are diligent about their NAV can be frustrated with the pricing services, said one manager.
“One of the big complaints most funds have about high yield from pricing services standpoint, is that it’s difficult to price and we have to be very diligent that the bonds in our portfolio reflect their value, we have a fiduciary responsibility to do that,” said the Midwest fund manager.