What is a bond really worth?

The age old question of what a bond is really worth was raised again this week when it was reported that the Securities and Exchange Commission is asking serious questions about how the world's largest bond shop, Pimco, valued some securities in its Total Return Bond ETF. Some markets for bonds can be notoriously opaque and illiquid, leaving advisers and investors with plenty of questions about the true value for a bond. And any news regarding Pimco and its eccentric, superstar co-founder — and now former fund manager — Bill Gross, will grab the investment advice industry's attention. The investment advice industry should expect regulators to continue their scrutiny of bond values, noted one industry executive. “Transparency in bond pricing is very much on the front burner for the SEC,” said Alexandra Lebenthal, president and chief executive of Lebenthal Holdings. “Bear in mind that there are tens of thousands of bonds, not all of which trade every day, so prices may not be up to date.” “When you have bonds that are so-called funkier credits that were part of a small issue, pricing may vary greatly, and liquidity could also be a problem,” she said. “As for the Pimco funds, remember that there are a number of derivatives which makes pricing all the more difficult.” But two recent actions by the Financial Industry Regulatory Authority Inc. against broker-dealers that sell relatively obscure securities known as “church bonds” also underscores the need for advisers and investors to investigate fully the truest price of a bond when dabbling in thinly traded securities. First, what on earth — or in heaven — is a church bond? According to the North American Securities Administrators Association, church bonds can be issued if they meet certain guidelines. The proceeds of such bonds primarily finance or refinance the purchase, construction or improvement of a church property, buildings, related educational facilities or related capital expenditures of a single church that is organized as a not-for-profit organization. Church bonds issued under these guidelines constitute a first mortgage lien on the church property that is pledged as collateral to secure the bonds, according to NASAA. And the bonds can be attractive. They can sport higher yields than corporate bonds or Treasurys because they are often not rated, are not guaranteed by a government agency, and investors often hold the bonds to maturity. Church bonds have been under the watchful eye of regulators for the past couple of years. Indeed, Finra in 2012 listed the bonds in its annual list of regulatory and exam priorities for the broker-dealer industry. “The credit quality of the underlying issuer and its true financial condition are often not transparent,” Finra said of church bonds in January 2012. “Investors may be unaware of the substantial credit and market risk they are assuming with such investments. The source and nature of the underlying revenue streams of the issuer that are required to service the instruments are often less than clear. Further, as sales are frequently made on an affinity basis, these securities can be vehicles for fraud.” So, the bonds can carry plenty of risk. Investors are “unaware” of certain potential pitfalls, while the cash flow of the issuer can be “less than clear.” While Finra made no allegations of fraud in its recent actions against two broker-dealers, Share Financial Services Inc. and B.C. Ziegler and Co., it highlighted alleged failures of disclosure and poor communications about the bonds to investors. In September, Finra filed a complaint against Share Financial and its president, Charles Major, alleging that the firm was in violation of Finra rules in connection with its offering of church bonds. In particular, Share Financial violated “advertising provisions by sending communications to the public that contained language that was oversimplified, incomplete, failed to provide a sound basis for evaluating the facts with respect to the products and services being offered, and contained unwarranted and/or misleading statements and claims,” according to the complaint. The alleged misconduct occurred from April 2011 to August 2011. The firm also allegedly had net capital and accounting errors, according to Finra. Mr. Major did not return calls this week seeking comment. In June, B.C. Ziegler entered into a settlement with Finra over a number of allegations around disclosure of important information having to do with the sale of church bonds. According to its report on BrokerCheck, B.C. Ziegler “used pieces of sales materials that were not fair and balanced and did not provide a sound basis for evaluating the facts about purchases of church bonds. The firm distributed internal-use-only church bond sales point memos to its registered representatives that failed to include risk disclosures addressing illiquidity and the potential loss of principal.” The firm was fined $150,000 in the settlement. The firm neither admitted nor denied the allegations in the settlement, according to its BrokerCheck report. Ziegler spokeswoman Sara Zick said the company declined to comment about the Finra settlement. Regular readers of this column know well its focus on illiquid securities, which typically come with high fees for the broker-dealer and the sales rep but which can pose a danger for advisers and their clients. Of course, when small or mid-sized broker dealers such as Share Financial and B.C. Ziegler face scrutiny over clarity around church bond sales, no one pays much mind. When the SEC asks Pimco questions about its method of bond valuations, headlines scream. For advisers, the renewed scrutiny by regulators on bonds is another reminder to question the value of illiquid securities, from church bonds or mortgage backed securities to real estate private placements. Is their risk worth the hoped for reward?