Pricey municipal bonds

Kathleen Pender,
San Francisco Chronicle
Thursday, February 12, 2004

A new study from the chief economist of the Securities and Exchange Commission says the cost of trading municipal bonds in the secondary market is significantly more than the cost of trading stocks, especially for individual investors.

"Municipal bonds are expensive for retail investors to trade," the SEC's Lawrence Harris says in his report, "Municipal Bond Liquidity," released Wednesday.

The study estimates that the average spread is 2 percent of the bond's price for retail investors, compared with 1 percent for large institutional shareholders. The spread is the difference between the prices at which a bond is bought and sold and is essentially the investor's cost of trading a bond.

Two percent "is the equivalent of almost four months of total annual return for a bond with a 6 percent yield-to-maturity," Harris writes.

He adds that spreads for similar-size retail stock trades "are rarely that high, even for the most illiquid stocks."

The report adds that investors in states with high income-tax rates generally pay higher transaction costs than investors in low-tax states. It lists California as the state with the third-highest maximum personal income- tax rate, after Montana and Rhode Island.

Many municipal bonds pay tax-exempt interest. Harris theorizes that investors in high-tax states are more eager to buy municipal bonds and drive a weaker bargain than investors in low-tax states.

Most individual investors who buy or sell previously issued bonds in the secondary market don't even know how much they're paying in transaction costs because they're embedded in the price of the bond. It's not easy to compare municipal bond prices and it's impossible to get same-day pricing of munis.

Individual investors own about one-third of muni bonds directly and more through mutual funds.

The Bond Market Association, which represents bond underwriters and dealers, took exception to the Harris report, saying it "appears to draw erroneous conclusions regarding both the structure of the municipal bond markets and the risks involved in trading and selling municipal securities."

The association's brief statement adds, "The municipal bond market is complex due to the large number of types of issues of all sizes and credits, which makes it very different from the equity and other fixed income markets. Comparing the two is not an accurate comparison."

The markets are very different indeed.

There are maybe 5,000 to 7,000 stocks that trade on the nation's major markets. Most stocks trade actively throughout the day, although the smallest ones trade less than once a day. Investors can generally get stock prices that are delayed by only 15 minutes.

By comparison, there are more than 1 million different municipal bonds issued by more than 50,000 state and local governments.

Issuers have dolled them up with all kinds of special features -- such as call provisions, sinking funds and credit insurance -- that make different bonds nearly impossible to compare.

Most bonds trade less than once a week, Harris says, and the most active ones trade less than six times per day.

There is no central exchange for muni bonds. The secondary market consists of brokers who trade with their customers and other brokers and dealers. The actual spread, or the price at which a broker is willing to buy and sell a bond, is not disclosed.

Until a few years ago, the prices at which municipal bonds actually traded were also deep, dark secrets.

In 2000, the Municipal Securities Rulemaking Board, which oversees brokers and dealers, began publicly disseminating prices for the most frequently traded bonds, with a one-day lag.

By June 2003, it was disclosing prices for all bonds, still with a one- day lag. (Prices are available at www.investinginbonds.com and www.municipalbonds.com.)

Next January, the board is supposed to begin disclosing same-day prices for all bonds within 15 minutes of the trade.

The Bond Market Association has asked the board to exempt large trades of low-rate or non-rated bonds from same-day disclosure.

The board is meeting this week to discuss, among other things, whether to grant an exception.

An SEC spokesman says the report was a project of Harris and his co- author and was not undertaken or sanctioned by the SEC itself.

Harris is a University of Southern California finance professor on assignment at the SEC. His co-author is Michael Piwowar, an Iowa State University assistant professor of finance, also on loan to the SEC.

Because actual spreads are still not disclosed, Harris estimated spreads using price data reported on bonds traded between November 1999 and October 2000.

In his paper, Harris argues that spreads would be lower if there were greater transparency, meaning more, better and faster disclosure of price data.

One bond-industry source, who didn't want to be named, says spreads are a result of the structure of the bond market and won't necessarily come down as a result of better transparency.

Zane Mann, who has been publishing a newsletter called the California Municipal Bond Advisor for several decades, says spreads today are low, compared with where they used to be.

"In my day, (spreads of) 5 percent were not normal but known," he says. "Now it's down to 1 percent or less" for most bonds.

Harris' report includes some findings that might help investors minimize their transaction costs.

He notes that complex bonds with lots of bells and whistles are cheaper to trade than simple bonds.

High-rated bonds are cheaper to trade than bonds with no or low credit ratings.

Newer bonds have lower spreads than seasoned bonds.

And bonds that mature soon have lower transaction costs than bonds that mature in the distant future.