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Municipal Bonds: What Investors Need to Know

Investors who are planning to invest in municipal bonds need to do their homework; if not, they may unknowingly give their first year’s worth of income to their broker. A June 7 article by the Wall Street Journal sheds a spotlight on the murky world of today’s municipal bond market – and what investors can and should do to minimize their risks and maximize their net returns.

As the article points out, “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.  And while U.S. Treasury yields also have risen recently, muni yields have truly skyrocketed.”

But before jumping on the municipal bond bandwagon, investors should proceed with caution,  industry experts say. Unlike what happens with stocks, you don’t pay a commission when buying a municipal bond. Rather, you pay a “markup,” which is the difference between a broker’s cost and the price an investor pays.

The markups themselves can be astronomical. And, unfortunately, most brokers don’t disclose their markup. Regulators and market analysts agree that many retail investors have no idea how much they’re getting charged on muni trades.

Securities Litigation and Consulting Group, a research firm in Fairfax, Va., recently analyzed nearly 14 million trades of long-term, fixed-rate munis over a period between 2005 and April 2013. (You can review the SLCG report here.)

The study found that on 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.

SLCG founder Craig McCann estimates that investors paid at least $10 billion in what he considers excessive markups since 2005. That is at least twice the normal cost to trade a given bond.

“That’s more than a billion dollars a year needlessly transferred from investors to dealers’ pockets,” McCann said in the Wall Street Journal story.

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