The Department of Labor’s (DOL’s) fiduciary rule could dramatically change the way that financial institutions interact with their clients. The government estimates that the new rule will have a $15 billion impact on the financial services industry, but private analysts believe that the true impact could be much more substantial. Several foreign banks have already exited the wealth management space, while independent advisor businesses are quickly going up for sale.
In this article, we will take a look at how these new regulations might affect the ~$4 trillion municipal bond industry over the long term.
New Fiduciary Rules
The DOL’s fiduciary rule is designed to align the financial services industry with that of the clients they serve. For example, many financial advisors make money by recommending mutual funds to clients in exchange for a kickback. These mutual funds often entail relatively high expense ratios, which can significantly reduce a client’s returns over the long term — to the tune of tens or hundreds of thousands of dollars.
When it comes to the municipal bond market, the DOL originally prohibited principals from directly purchasing and selling muni bonds from or into a client’s retirement account. The intent of the rule was to reduce the likelihood that a principal was simply unloading risky bonds from their own holdings into their clients’ or buying them at a discount. However, the rule was later amended to permit only the purchasing of bonds from clients.
The DOL’s rules also prohibit many ancillary fees from being imposed on retirement accounts in order to try and reduce expenses. Unfortunately, these rules may cause unintended consequences when it comes to providing services like fee-based bond laddering. These kinds of services are the cheapest way for smaller retirement account holdings to maintain proper exposure to muni bonds without taking on excessive duration risks.
Impact on the Market
The good news is that the DOL’s latest stance on municipal bond sales between a principal and client should help clients maximize their ability to sell during times of economic turmoil. For instance, if a client is holding Puerto Rican muni bonds that have become too risky for a client’s account, a principal that’s willing to buy may be able to offer liquidity and enable the client to reduce their exposure to a troubled region.
The problem is that preventing principals from selling to clients doesn’t necessarily mean that those clients can’t buy the muni issue. Rather, they are simply unable to buy it from a principal that may be offering a better deal than other broker-dealers. The client may therefore miss out on the best possible price and end up overpaying for a muni bond issue – particularly in a market that is notoriously illiquid — despite being required to put the client’s best interests first.
Wealth management firms may also have to change the way that they provide muni bond-related services to clients. For example, some firms provide bond laddering services on a commission basis to smaller retirement accounts, which may be forced to move them to a more expensive percentage-of-asset model. These dynamics could price many smaller retirement account holders out of the market and restrict some demand from the muni bond market.
The Bottom Line
The DOL’s fiduciary rule could have a huge impact on the financial services industry. When it comes to municipal bonds, the DOL’s rules permit principals to purchase muni bonds from clients but forbid them from selling the bonds to clients. The rules could also limit the ability to provide cost-effective bond laddering services to smaller retirement accounts. Unfortunately, both of these developments could have a negative impact on the market.