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Buyer Beware: The Hidden Costs of Municipal Bonds

By: Richard Feldman

By: Richard Feldman, CFP, MBA

I am going to let you all in on a little secret that may come as a shock to some of you. Institutional investors get better prices than individual retail investors. Nowhere is this adage truer than in the municipal securities market where transaction fees are not listed but instead are built into the price of the purchase or sale transaction. This is commonly known as the spread on a bond and could end up costing the buyer or seller a great deal of money.

Municipal Bond Market

There are more than 1 million different municipal bonds issued by more than 50,000 state and local governments. In a typical year, fewer than 1% of those million issues make up half the trading volume in the entire municipal market and roughly 70 percent of all munis will never trade even once for the year.

There is no central exchange for municipal bonds. Municipal bonds that are already issued trade on the secondary exchange which consists of brokers who trade with their customers and other broker dealers. There are approximately 1,600 bond dealers that trade munis and of these, five are responsible for more than half of the total trading volume.

Spreads

A new study from the chief economist of the Securities and Exchange Commission says the cost of trading municipal bonds in the secondary market is significantly more than the cost of trading stocks, especially for individual investors. Municipal bonds are expensive for retail investors to trade,” the SEC’s Lawrence Harris says in his report, “Municipal Bond Liquidity”. The study estimates that the average spread is 2 percent of the bond’s price for retail investors, compared with 1 percent for large institutional shareholders. The spread is the difference between the prices at which a bond is bought and sold.

Most individual investors who buy or sell previously issued bonds in the secondary market have no idea how much they are paying in transaction costs or the spread. Typically bond sales or purchases are shown to retail customers as a net number meaning the spread is never disclosed to the client.

“Recently the National Association of Securities Dealers (organization in charge of regulating brokers) cracked down on eight major firms that the NASD asserts did not meet their obligation to “buy and sell municipal bonds at fair prices.” The firms neither admitted to nor denied the charges, paying $610,000 in fines and restitution to settle with the SEC. A customer selling through Merrill Lynch, the NASD claims, got $2,890.50 for a bond that another dealer traded later that day for $6,229 – meaning Merrill sold the bond for its customer at less than half the fair value. At Charles Schwab, says the NASD, one client received only 70 cents on the dollar for a bundle of bonds with a fair value of 97 cents – a difference of $13,500 on $50,000 in principle. In fact, the NASD found that the brokers did not bother to find out what the bonds were really worth before they bought them from their clients.”[1]

Pricing Information on Municipal Bonds

In 2000, the Municipal Securities Rulemaking Board (MSRB), which overseas brokers and dealers, began publicly disseminating prices for the most frequently traded bonds. By June 2003, the agency was disclosing prices for all bonds on a next day basis. The price data is available at www.investinginbonds.com and www.municipalbonds.com The board is supposed to start disclosing trade prices within 15 minutes of the transaction by this coming January.

Solutions to the Problem

Bond funds: Because institutional investors get better pricing than retail investors a bond mutual fund that invests in municipal securities is almost a free lunch. Retail investors are paying almost a full percent more to buy individual municipal securities than the institutional investors. If you can’t beat them join them. Make sure you select a fund with an expense ratio lower than .50% or 50 basis points. Many fund companies such as Vanguard, Fidelity, and T. Rowe Price should be able to accommodate you. In addition Vanguard and Fidelity have Admiral and Spartan shares that give you an even further discount if you meet their minimum purchase requirements.

Liquidity: Stick to the names that are the biggest and most liquid in the market meaning they are traded frequently. In addition hold your bonds till maturity so you will only get hit with one transaction spread rather than two.

Quotes: Ask your broker questions on the markup of the bond. Make him tell you what the most recent purchase and sales data was for the individual bond you are dealing in. The data should be available from the previous websites I had mentioned.

Summary

The Municipal Securities Rule Making board has pricing rules regarding municipal securities. Rule G-30 on prices and commissions and rule G-18 on the execution of transactions – require brokers’ brokers and dealers to obtain fair and reasonable prices for customers. The fair and reasonable is based on market prices, not on profits. Don’t assume that your broker is following these rules. Make sure you keep him honest by doing your homework. An educated buyer or seller will have a better chance of obtaining fair market prices.

[1] The Dark side of the Muni, Zweig, Jason, CNN Money, August 20, 2004