Be Cautious of Municipal Bond Costs

Municipal bonds (also known as "munis") are beginning to look tempting — but investors who buy munis in a hurry can sometimes hand over their first year’s worth of income to their broker, writes Jason Zweig in a recent article for Wall Street Journal.

However, with a few simple steps, you can control your risk and maximize your net return.

The health of many municipalities is improving even as tax-free bonds offer relatively attractive returns. Yields on the highest-quality, widely traded munis, triple-A-rated, 10-year “general obligation” bonds, have risen by 0.45 percentage point since May 1, according to a senior market strategist at Municipal Market Data.

While U.S. Treasury yields have risen recently, “muni yields have truly skyrocketed,” says a chief municipal strategist. “We’re approaching the levels where retail investors will start to raise their hands again. The pent-up retail demand is very strong.”

Investors should proceed with caution, or they can lose their investment. Unlike stocks, the investor doesn't pay a commission when they buy a municipal bond. Instead, the investor pays a “markup”—the difference between the broker’s cost and the price the investor pays.

Most brokers don’t disclose their markup. Because they focus too much on yield and not enough on price, “most retail investors have no idea how much they’re getting charged on these trades,” says an asset manager in New York specializing in municipal bonds.

Markups can be huge. The WSJ article points out that for one out of 20 trades, people who bought $250,000 or less in municipal bonds paid a markup of at least 3.04%—or approximately a full year’s worth of interest income at today’s rates. By comparison, you will pay less than $10 in commission to buy a stock at most online brokers, or 0.004% on a $250,000 purchase; a typical mutual fund charges management fees of about 1% a year.

Of the approximately 1.2 million issues outstanding, only about 14,000 trade at all on any given day, according to the Municipal Securities Rulemaking Board, a regulatory body that oversees the muni market.

Brokers rightly point out that it can be difficult and costly to find any particular bond on a given day. Federal rules require that markups be “fair and reasonable” but don’t define those terms exactly.

There is no reason why you should pay a much higher markup than someone else recently did for a similar-size trade in the same security writes Zweig.

The MSRB maintains a website, Electronic Municipal Market Access, or Emma, that shines some much-needed sunlight into this shadowy world.

“[Brokers] respond if they know you’re looking over their shoulder,” says Ernesto Lanza, the deputy executive director of the MSRB. “If you’re buying a bond, look at all the ‘customer bought’ trades to see what other customers paid. Then say to your dealer, ‘Try to match this.’”