Cities, towns, states and their agencies issue tax-exempt bonds via the primary market (i.e., the market for new issues). These "deals" are sold either through a negotiated offering with a specific investment bank, or by means of a competitive bid process between a number of investment banks.
The bond issuer is largely responsible for the structure of the deal, in terms of its maturity schedule and redemption features. The underwriter of the deal then sets the coupon and interest rates. In a competitive new issue, the underwriter generally determines whether the bonds will use credit-enhancing insurance, such as that offered by MBIA, AMBAC, FGIC or FSA. Fifty to sixty percent of the new issue market is insured; a figure that reflects the low cost of insurance, which in turn reflects the creditworthiness of municipal bonds.
Once underwritten, the bond issue is free to trade in the secondary market. This market is supported through the broker/dealer community, which puts buyers and sellers together. Acting as a dealer, a firm buys bonds for its own inventory to resell. Broker/dealers do not charge commission, working instead for the spread between the bid and offer.
What makes the municipal bond secondary market unique to most other securities markets is its fragmented nature. In direct contrast to the corporate bond market, there are a large number of small outstanding issues. In addition, the vast majority of municipal trades in the secondary market are for principal amounts less than $100,000.
The marketplace addresses this dynamic through a large network of regional broker/dealers. Regional dealers develop expertise in their particular markets, and are thus able to provide secondary market liquidity for even the most obscure issuers.
