You May Be Paying Hundreds in Hidden Bond Fees

(MoneyWatch)  Morgan Stanley was fined $90,000 and ordered to make restitution of more than $40,000 due to charges of abusive trading practices related to corporate and municipal bond trades. This serves as another illustration of some of the dangers of buying bonds through broker-dealers.

According to the Financial Industry Regulatory Authority Inc., Morgan Stanley consented to the findings that it "sold or bought corporate bonds to or from customers and failed to sell or buy the bonds at a price that was fair, taking into account all relevant circumstances."

Generally speaking, firms can change the price of bonds as they see fit. Unfortunately, the Municipal Securities Rulemaking Board (MSRB) provides almost no guidelines as to a limit on the amount a broker-dealer can mark up or down the price of a bond. The only guidance is what is known as Rule G-18. It requires that brokers trade at prices that are "fair and reasonable in relation to prevailing market conditions." In Morgan Stanley's case, two municipal bond transactions were marked up 7.41 percent and 6.98 percent, and one was marked down 22.98 percent.

Given that the makeup of the MSRB member board is five representatives from bank dealers, five representatives from securities firms, and just five representatives from the public, it's easy to see that any oversight is biased in favor of the industry, not the investor.

Also unfortunate is that the SEC doesn't require broker-dealers to disclose the amount of markup or markdown charged. The result is that transactions costs in bond trades can be like icebergs, where the largest part is hidden beneath the surface.

When buying bonds, the danger is that because the only required disclosure is the transaction fee (which is an administrative fee, not a commission), most investors assume it's the only cost they'll incur. This is definitely not the case. As Morgan Stanley's actions illustrate, it's just the tip of the iceberg. Without the assistance of the technology needed to identify markups and markdowns, you can incur large costs without even knowing it.

Markups and markdowns can be very large since there's little in the way of regulations to prevent abuses. In a May 2002 ruling, SEC administrative law judge Lillian McEwen dismissed fraud charges brought by the SEC and the MSRB against a Los Angeles broker. McEwen concluded: "Markups and markdowns on municipal securities ranging from 1.87 to 5.64 percent were not excessive and did not violate the securities fraud laws."

Whenever we meet investors for the first time, we check their bond transactions to show them the spread they were charged. Quite often, they're shocked because they were either led to believe the only fee was the transaction fee or they were told the spread would be 1 percent and it turned out to be much higher than that.

Although brokerage firms are legally allowed to charge undisclosed markups ranging upward of 5 percent, the practice is unfair because it takes advantage of investors who might not be aware that bonds commonly include markups from a broker-dealer. Whether legal or not, fees of this size are certainly not in the interest of the investor, and the failure to disclose them is an indication that broker-dealers would agree.