Are you aware of the hidden costs in municipal bonds?Submitted by Maze Financial Planning, LLC on September 1st, 2016
One of the most important reasons we chose to be a part of the BAM Alliance is the fixed income services. This lets our small boutique firm, operate on an institutional level for purchasing fixed income securities. Meaning, BAM puts dealers into competition with each other to reduce the price of a bond, which subsequently increases the yield a client receives. If you go to your traditional broker, bonds are sold at significant mark ups. Congress passed the Securities Acts Amendments of 1975 which created a system for clearing and settlement of securities transactions nationwide and created the Municipal Securities Rulemaking Board (MSRB). The effect was to create a more transparent market place for equity and municipal securities. This increased transparency made it so analysis could be conducted and gave light to a strong difference in price for retail and institutional investors.
A markup is the difference between the price paid by a broker/dealer and the price a bond was sold to a client. Broker/dealers are permitted to charge fair and reasonable markups on bonds. Unfortunately, these markups do not have to be disclosed to the client. Because of this, the nominal ticketing fee on the client’s trade confirmation is often assumed to be the only cost, similar to a stock purchase. With markups not having to be disclosed, it is not surprising that many investors are surprised when they find out the true costs associated with purchasing bonds. Bonds are traded in an over-the-counter market where broker/dealers trade with each other. By comparison, equity markets trade on an exchange (such as the New York Stock Exchange). Because there is no centralized exchange for bonds, pricing is more opaque and difficult to determine. As a result, bond dealers have an advantage over retail investors, and many exploit this by charging large markups without the client’s knowledge. Let’s take a look:
The example above illustrates how the investor received a price of 113.18, which equates to a yield of 2.64 percent. The dealer, on the other hand, purchased the bond at a significantly lower price of 111.50, or a 2.80 percent yield. The dealer marked each bond up to $1.68, or $3,360 in total of which the client had no knowledge. This is a common practice. A 2014 Wall Street Journal article cited a study that showed that individual investors trading $100,000 in bonds of a municipality paid brokers an average spread of 1.73 percent, or $1,730.
We work with BAM’s Fixed Income department, which functions as a Registered Investment Advisor and, as such, cannot legally charge markups on any bonds purchased for clients. This doesn’t totally eliminate markups, however, because bonds still need to be purchased from other dealers in the market. What BAM’s Fixed Income Desk can do, though, is drive those markups down as much as possible by putting our dealers in competition for each trade, which can drive down the per-bond price and is in stark contrast to what is illustrated above.
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