The municipal bond market is often considered to be a safe-haven asset class for investors due to its government backing and tax advantages. Unfortunately, the financial markets are common targets for fraud and the muni bond market is no exception. The fraud taking place in this market may not be as outright as equity markets – where executives may outright lie – but fraudulent strategies to artificially influence interest rates can still cost investors money.
Below, MunicipalBonds.com takes a look at a recent example of fraud in the municipal bond market and what it means for investors holding these bonds.
Banks Rigging Derivative Prices
The municipal bond market faced its biggest fraud settlement in years when at least five banks agreed to pay more than $740 million in penalties, restitution, and disgorgement for conspiring to fix prices for muni bond derivatives. According to plaintiffs in these cases, the actions led to lower interest rates than they would have gotten in a competitive marketplace, which cost them hundreds of millions of dollars in lost income.
The plaintiffs were large organizations such as the City of Baltimore and the Central Bucks School District in Pennsylvania, which invest the proceeds of their own bond sales that they do not need to spend immediately. These proceeds were invested in muni bond derivatives that were rigged to pay out below-market interest rates. The plaintiffs alleged that many large banks took peaks at rival bids and purposely submitted non-winning bids in an abuse of the process.
While these kinds of cases don’t directly impact individual muni bond investors, they may be costing taxpayers a lot of money. These kinds of frauds may also reduce the interest rates being paid on bonds in an investor’s portfolio if the derivatives can be exercised into the market.
Cities Misleading Muni Investors
Misleading investors is a much more common type of municipal bond fraud that directly impacts individual investors in the municipal bond market.
Federal prosecutors made a similar case in San Diego that year when it alleged that the city intentionally failed to disclose to muni investors its significant pension and retiree health care liabilities and the difficulty that the city would have funding those liabilities. Three city officials in that case ended up paying a collective total of $80,000 in fines for not including those risks in bond disclosure statements, which could have adversely impacted investors.
The Bottom Line
The municipal bond market is often regarded as one of the safest market for investors, but that doesn’t mean that fraud never takes place. Six different banks were recently charged with rigging derivative prices that could influence the yields on muni bonds. In past years, many states were also charged with misleading investors by omitting key risks related to pension funds, health care requirements, or other potentially dangerous liabilities.
Investors should take the time to evaluate municipalities outside of the prospectus in order to help avoid these problems. At the same time, it’s important to establish a diversified portfolio of muni bonds in order to reduce the risk of any single bond causing problems.
