The municipal bond market is a popular safe haven during low interest rate periods, as their tax-advantaged nature helps boost after-tax yields. Although wealthier individuals stand to benefit the most with their higher marginal tax rates, all kinds of investors participate in the market through both individual bond purchases and muni bond exchange traded funds (ETFs). The big question is whether individual bonds can be as cost-effective as ETFs for investors.
In this article, we will take a look at some tips to avoid overpaying for individual muni bonds.
Reconsider Bond Insurance
Most municipal bonds are issued in $1,000 increments with a minimum of five lots, which means investors must pay at least $5,000 for each bond purchase. The most interesting opportunities have even higher requirements of 10 to 50 lots worth $10,000 to $50,000 per bond purchase. As a result, those without at least $500,000 to invest may quickly find themselves worried about the amount of money committed to a single issuer.
Brokers recognize these fears and often try to sell bond insurance from companies such as Assured Guaranty or Financial Guaranty Insurance Company that promise to pay interest and principal if a bond defaults. In general, this insurance costs between 10 and 30 basis points, which takes a sizable bite out of the bond’s overall after-tax yield. These fees can add up over time across multiple bonds and transactions and work against an investor’s long-term objectives.
Most investors purchasing A-rated or higher muni bonds have little need for this kind of insurance given the extremely low default rates. Since 1970, the default rate on A-rated or better bonds has been just 0.03%, which means insurance is rarely worth the money. Many insurers have also experienced problems of their own during the 2008 financial crisis given their exposure to subprime mortgages and may not be entirely reliable either.
Avoid Overpaying Brokers
Most traditional full-service brokers charge two points for retail bond transactions, which translates to 2% of the market value of the bond. For instance, a broker might purchase a bond for $980 and sell it to an investor for $1,000. These fees can quickly add up when transactions approach $50,000 or greater in size, as is the case with most muni bonds, since the fees immediately reduce the after-tax return.
The best way to avoid these unnecessary expenses is to purchase muni bonds through discount brokerages that charge a fraction of a point. Through these platforms, it’s important to note that many bonds are listed for prices higher than the current market price and it might make sense to bid lower to get a better price. Investors may even be able to find attractive opportunities in bonds that are flying under the radar of institutional investors.
Investors may also want to consider purchasing muni bonds directly through primary market deals. In many ways, this is similar to purchasing a stock through an initial public offering rather than buying it from another investor. Investors may be able to pay the same fees as larger institutions acquiring bonds in the primary market, which translates to a fairer price for investors that may not be possible in the secondary markets.
The Bottom Line
The municipal bond market is relatively illiquid compared with traditional equity markets and more popular bond markets such as the Treasury market. Because most market participants are institutional investors, it can be difficult for individual investors to keep costs low and ensure optimal portfolio yields. The tips mentioned in this article can help individuals keep these costs low and get the most out of their investment.