Bidding on an $8 Million Callable Turnpike Block
A dealer's municipal desk is asked by an institutional customer to bid on $8 million of 5.00% coupon turnpike authority bonds due 2040, rated A, first callable in 2034 at 101. Comparable A-rated toll road paper is currently offered at 4.55% for 10 years and 4.80% for 20 years. The last trade in this line was three weeks ago: $2 million at 4.35%. The customer gives the desk a 30-minute window and asks for a 'real market,' saying she only looks at yield to maturity. The desk already holds $6 million of this issuer, and the firm's single-issuer limit is $10 million.
1. Determine a bid and explain how the call feature, size, and current inventory affect your number.
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Start from the curve. 2040 is 16 years out. Interpolating between 4.55% (10y) and 4.80% (20y) gives roughly 4.75% on the offer side for this credit.
Adjust for staleness. The 4.35% trade is three weeks old and only $2 million. In a market that has moved, it is not the reference; the comparables are.
Compute yield to worst. With a 5% coupon and a 2034 call at 101, the call matters. If the bond trades near or above par, yield-to-call will drive the worst-case outcome. Calculate YTM and YTC and bid off the lower number.
Add a concession for size and urgency. An $8 million block is illiquid relative to the $2 million trade, and the desk has 30 minutes. A bid several basis points wide of the offer side - roughly 4.85% to 4.95% on the worst-case yield - is defensible, but the desk must document the rationale.
Inventory is the binding constraint. $6 million existing plus $8 million would be $14 million against a $10 million limit. The desk cannot simply bid for the full block. Options: bid for $4 million, pair off part of the existing position before bidding, or obtain a documented limit exception. The customer should be told which it is.
2. What must the desk show the customer, given she says she only looks at yield to maturity?
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Show more than she asked for, and say why.
- Present yield to maturity, yield to call, and yield to worst, plus the call schedule and call price. A callable bond quoted only to maturity is misleading whenever the call produces the lower yield.
- State the basis of the quote. It is a bid, and it is subject to the size and time constraints stated.
- Disclose the inventory constraint. If the desk can only bid for part of the block, say so up front rather than after the fact.
- Fair pricing. MSRB Rule G-30 requires prices fair and reasonable relative to the market; the comparable trades and the curve are the evidence that the bid meets that standard.
- Fair dealing. Rule G-17 supports the full disclosure of the call feature and the yield measure, even when the customer says she does not want it.
Document what was shown and when.
3. The customer says the bid is 50 basis points wide of the last trade and accuses the desk of lowballing. How do you respond?
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Explain the components rather than defending a single number:
- The last trade was small and stale. $2 million three weeks ago is not a benchmark for an $8 million block today.
- The market moved. Show her the current comparable levels and, if available, recent prints in similar toll road credits.
- Size and liquidity cost money. A block the desk must warehouse carries re-marketing risk; that is reflected in the bid, not hidden.
- The call is priced in. Part of the gap may be the yield-to-worst adjustment, especially if the bond is near par.
A wide bid is not a rule violation if it is fair relative to the market and the size; an unjustifiably low bid would be a G-30 problem. Offer to show the comparables and to bid on a smaller size at a tighter level. Document the conversation and the market evidence in the file.