2004-02-11 15:30 (New York)

U.S. Retail Muni Bond Trades Cost Five Times More Than Stocks

By Darrell Preston
Feb. 11 (Bloomberg) -- Retail investors pay five times more to buy and sell municipal bonds than stocks because there isn't enough price information available in the $1.9 trillion U.S. municipal securities market, the Securities and Exchange Commission said in a study released today.

``The conclusions of the study support moving to real-time pricing,'' said Martha Mahan Haines, head of municipal securities regulation at the SEC, in a phone interview. ``Putting information in the hands of investors is a fundamental principle of the securities laws.''

Haines said the study would be used by the SEC in determining how soon to push the Municipal Securities Rulemaking Board to begin disclosing prices within 15 minutes of a trade. The MSRB, the self-regulator that makes rules for bond dealers, began collecting price information in 1994 and now releases prices the day after a trade.

Spreads for retail municipal bond investors average 198 basis points, compared with 40 basis points for retail stock trades, the study said. Spread is the difference in price, or the markup or markdown, charged when an investor buys or sells a bond to a dealer. A basis point is 0.01 of a percentage point.

Thus an investor would pay $198 to invest $10,000 in a municipal bond and $40 to invest $10,000 in stock.

``There's a lot of ways of hiding the markups on these securities and it has been happening for decades,'' said Richard Lehmann, publisher of Income Securities Advisor, a newsletter for individuals who buy fixed-income securities. ``This is a storm that comes up every year or two but nothing happens. The people in this industry aren't interested in change.''

The MSRB has said it plans to disclose prices within 15 minutes by next January. The MSRB's board is scheduled to meet later this week in Hawaii to resolve disclosure issues before setting a timetable for moving to real-time pricing.

Real Simple
Investors would have lower trading costs and issuers of municipal bonds would have lower borrowing costs if municipal bonds were simplified, the report said. Trading of municipal securities is complicated because each of the more than 1 million distinct municipal securities has different call dates, sinking funds and credit enhancement that affect the value of the securities, the report said.

The report was written by Larry Harris, chief economist at the SEC, and Mike Piwowar, visiting academic scholar in the SEC's Office of Economic Analysis.

Retail investors, who directly own about one-third of municipal bonds, lose the equivalent of almost four months of total annual return on a bond with a 6 percent yield to maturity, the report said. For the report released today, the researchers studied 167,000 trades reported to the MSRB from November 1999 through October 2000.

Why Pay More?
Retail investors pay more because ``large institutional traders generally have a good sense of the values of municipal bonds, whereas small traders do not,'' the report said. Spreads on municipal bond trades average about 2 percent of the price for retail trades of $20,000 and about 1 percent for institutional trades of $200,000, the report said.

Haines said that while the report acknowledges that municipal bond investors pay more than stock investors, part of the higher cost is justified by the differences in the markets and the differences in the types of securities. Bonds are traded over the counter while stocks trade on central exchanges.

``The only credible explanation for the cost difference is that the market structures differ, and the most important difference is transparency,'' the authors wrote in the report titled ``Municipal Bond Liquidity.''

Real-Time by Next Year
SEC Commissioner Cynthia Glassman wants the MSRB to meet the goal of disclosing ``all trades on as close to a real-time basis as possible'' by January 2005, she said in a Feb. 3 speech to the Bond Market Association.

``The increased transparency to date has permitted increased regulatory surveillance of the muni market,'' Glassman said in the speech, according to a transcript.

On Jan. 26 the Municipal Securities Rulemaking Board said that it found trading patterns that ``show an abnormally large price variance in a relatively small number of issues each day,'' and issued a reminder to dealers on rules for prices and markups.

No Limits
The MSRB, however, doesn't set specific limits on markups or markdowns, instead requiring dealers to determine what is ``fair and reasonable.'' Dealers ``must exercise diligence in establishing the market value of the security and the reasonableness of the compensation,'' the MSRB said Jan. 26.

The MSRB makes rules for municipal securities dealers, and the SEC and National Association of Securities Dealers enforce regulations on markups. The SEC is examining whether municipal and corporate bond dealers are charging inappropriate commissions, Stephen Cutler, enforcement director, said at the Feb. 3 Bond Market Association meeting. He declined to elaborate or disclose whether any bond dealers are under scrutiny.

In the U.S. 50,000 units of state and local government have sold municipal bonds totaling $1.9 trillion, the report said. The MSRB has 2,700 registered brokers and dealers.

Christopher Taylor, executive director of the MSRB, and officials with the Bond Market Association, which represents fixed-income securities dealers, didn't immediately return phone calls seeking comment.

Haines said a second study of pricing in the municipal bond market has been completed by the SEC and would be released when it's approved by officials with the commission.

--With reporting by Robert Schmidt, Jed Horowitz and Jack Duffy Editor: Conley.