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Evaluated pricing for illiquid instruments

Karl Mackelburg
Karl Mackelburg
Director, Fixed Income Valuations, Refinitiv

Using evaluated pricing to establish the fair value of narrowly held financial instruments: private placement debt and church bonds. Karl Mackelburg, Director of Fixed Income Valuations at Refinitiv, explains.


  1. Evaluations for illiquid instruments require unique insight and expertise.
  2. Asset managers, especially within the insurance industry, attracted to private placements for their unique cash flow features, have traditionally relied on internal pricing.
  3. While sharing some similarities with private placements, establishing fair value for church bonds is even more difficult. Issuance size is extremely low and they cater to a narrow group of investors.

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Historically low interest rates have helped fuel a surge in debt private placements in recent years.

According to a 2020 report from MetLife Investment Management, the U.S. private placement market generated an estimated $100bn in transactions in 2019, nearly double the reported transactions in 2015.

Long a haven for institutional investors looking for higher rates than can generally be found in the public fixed-income markets, private placements tend to match higher yields with better downside protection. That’s been a particularly attractive combination for the insurance industry, which has to match long-term assets to liabilities within tight tolerance parameters.

In today’s persistently low-interest-rate environment, more institutional investors have begun moving into the market, driving up demand for price evaluations.

Evaluated pricing service: Pricing valuations you can count on

On the other end of the fixed-income spectrum are church bonds, which are exclusively retail products with no secondary market. While they have some similar characteristics to private corporate bonds, church bonds tend to be significantly smaller and cater to a much narrower audience – usually just the congregation itself.

They are typically used to fund capital campaigns, such as a new building or restoration of an existing structure, and investors are guided more by their desire to support their church than by portfolio performance.

Much like their private equity brethren though, church bonds present unique challenges to buyers and borrowers, alike. Key among them is establishing a fair – and defendable – value to these inherently opaque securities.

How do you price something you can’t see?

For the vast majority of investment securities, the markets set the price. Highly liquid, exchange-traded stocks, such as Apple and Amazon, generate reams of market data every day.

On the fixed-income side, even if they aren’t as actively traded, public bond offerings still generate enough information to build a solid pricing foundation.

For one thing, publicly traded bonds require a debt rating from a qualified rating service, and investors have access to both the corporate financial statements and to the terms and conditions baked into each bond offering. In the United States, many bond trades are disseminated to the public through the Financial Industry Regulatory Authority (FINRA) and the Municipal Securities Rulemaking Board (MSRB).

With private placements and church bonds, though, valuers are often flying blind. Borrowers don’t need to get a public credit rating on their debt. They don’t need to open their books to third parties, and the terms and conditions underlying the bond agreements are private.

Then there’s the issue of liquidity.

There are limited markets for private placements and virtually nothing for church bonds. Most investors hold these instruments to maturity. Also, without a secondary market, there’s no observable data to support price values.

Church bonds have added complexities. First, most bonds are backed by the value of the church’s real estate holdings, which can be impacted by a broad range of local, regional, and national economic factors. Second, churches are as unique as their congregations, so there is no broader sector information to help support pricing.

Furthermore, the repayment of church bonds is directly dependent on congregation donations, and church membership and attendance have dropped dramatically over the last two decades. As private, non-profit entities there are no comprehensive data sources covering church closings, bankruptcies or bond offerings.

Building evaluated pricing models

With limited market data to support these highly illiquid investments, evaluated pricing models depend on a variety of inputs.

For example, large issuers – think General Electric or IBM – typically issue several different types of bonds. If the issuer also has public debt, those ratings can be used to support private placement values. Without a public market price comparison, though, investors are dependent on the internal credit rating provided by the issuers themselves.

For private placements, sector analysis can also be used to support values. Unfortunately, none of these inputs are generally available for church bonds, except for primary market issuance levels. Values are often built on more subjective inputs, such as how well pastors are received by their congregations and their ability to fundraise.

This presents a unique challenge for financial advisors who need to incorporate church bonds into client portfolios, notes Dylan Richards, Vice President of Operations for LPL Financial. Clients come to their financial advisor with these investments – not the other way around – and the advisor has no way to value that bond within the portfolio. “Without a third party providing an evaluated price, that asset is carried on the books as zero”, Richards says.

That means that advisors working under on a fee structure based on assets under management can’t bill for that holding. They also can’t represent it effectively within an asset allocation model. An added complication for the custodian is that, in order to meet audit compliance, each church bond needs to be priced daily.

Evaluating evaluators

With all of these variables and unknowns, there is no such thing as a ‘perfect’ price in these illiquid markets. That’s why firms need to find a valuation/pricing partner with deep insight and extensive expertise in every sector they cover.

Here are the key characteristics firms should consider when searching for an evaluated pricing vendor that they can trust:

  • Transparency: the extent to which a provider offers transparency into the methodologies, models and inputs underpinning its valuations processes.
  • Expertise: the level of experience and intimate understanding behind the inputs underpinning the provider’s valuations, specifically with respect to the securities its practitioners are working with.
  • Accuracy: the historical accuracy of the provider’s prices and valuations, and the extent to which they can be relied upon.
  • Relationship: the extent to which a provider’s relationships with its clients can be described as partnerships or collaborations.
  • Technology: the provider’s technology stack in terms of how easy it is to live with on a daily basis. Some providers’ prices/valuations are delivered in the form of a downloadable file, while others offer more flexible, interactive services.
  • Network: the extensiveness of a provider’s operating network. Some providers offer genuinely global coverage, while others suffer from regional gaps.
  • Price: the extent to which a provider’s prices are consistent with others in the market, and whether its prices are commensurate with the services it provides.
  • Responsiveness: some providers are more responsive than others when they are questioned about a valuation query. Some have specialists available to field calls and provide immediate feedback, while others do not.
  • Community: the extent to which a provider supports a ‘client community network’, whereby all its clients are able to benefit from resolved client challenges, problems and feedback.

Not all providers are created equal.

The quality of the evaluations is directly related to the scope of the data available and the network of internal resources, external data partners, and the market makers providing input.

With no regulatory oversight of the private placement market and increasing regulatory scrutiny over how banks and other financial service institutions manage their portfolios, it’s more important than ever to have a trusted partner evaluating these assets for you.

Evaluated pricing service: Pricing valuations you can count on


Faqs

How can you use evaluated pricing to establish the fair value of narrowly held financial instruments?

With limited market data to support these highly illiquid investments, evaluated pricing models depend on a variety of inputs.

For example, large issuers – think General Electric or IBM – typically issue several different types of bonds. If the issuer also has public debt, those ratings can be used to support private placement values. Without a public market price comparison, though, investors are dependent on the internal credit rating provided by the issuers themselves.

For private placements, sector analysis can also be used to support values. Unfortunately, none of these inputs are generally available for church bonds, except for primary market issuance levels. Values are often built on more subjective inputs, such as how well pastors are received by their congregations and their ability to fundraise.

This presents a unique challenge for financial advisors who need to incorporate church bonds into client portfolios, notes Dylan Richards, Vice President of Operations for LPL Financial. Clients come to their financial advisor with these investments – not the other way around – and the advisor has no way to value that bond within the portfolio. “Without a third party providing an evaluated price, that asset is carried on the books as zero”, Richards says.