A few months ago, I wrote about Municipal Bonds and the industry's dirty little secret, calling into question the huge total costs in trading individual bonds. As a result of this blog, I was contacted by Robert Kane, CEO of an amazing new web site called Bondview.com. With this free website, investors can look at the individual trading history of municipal bonds. This is the first site I've found that gives so much transparency to the over-the-counter bond trading business. It appears I may have underestimated the trading costs in my original article.
A shocking example
Not too long ago, an investor came to me having just sold five municipal bonds, totaling $435,000, on Fidelity's web site. Because muni bonds are so thinly traded, I was able to use Bondview.com to track what happened to each bond. Here's a typical example:
In looking at this data, the investor sold this bond at 2:39 PM for $96.50. In the next 52 minutes, two broker dealers traded this bond and sold off three quarters of this position for $100.00 per bond. That's more than a four percent markup!
The largest spread of this five bond batch was a bond sold for $89.40, in which the next investor purchased two days later at $99.16. That ends up being a 10.9 percent markup, or more than two years' yield of this particular bond. Kane noted that he had seen bonds trade in spreads of 10 to 15 percent on the same day. I certainly agree we shouldn't make a conclusion on a sample size of five trades, though it bears mentioning that I've yet to track one bond that had less than a two percent spread between the seller and the investor who ultimately bought the bonds.
Who profits from these spreads?
Who made this profit? It's hard to tell. As was the case with nearly every bond I've followed using Bondview.com, other broker dealers seemed to be involved. According to Kane, not all of these broker dealers are necessarily independent of each other. Fidelity happens to own two broker dealers.
Fidelity spokesperson, Steve Austin, stated the firm does not comment on specific transactions. He did note that Fidelity is among the top firms in the business, but there are large price fluctuations in thinly traded securities. Fidelity advises investors to educate themselves, said Austin. While I don't have a statistical study, the spreads I've seen at Fidelity seem comparable with those of other brokerage firm bond desks, so I don't mean to single out Fidelity.
An alternate viewpoint
My Moneywatch colleague, Larry Swedroe, disagreed with my last piece in a column he wrote entitled The Truth about Mutual Fund Costs. Swedroe wrote that his firm had an average inter-dealer trade margin of 0.17%, clearly less than I saw with the Fidelity trades, and that's a great thing.
Unfortunately, the spreads on inter-dealer trades are not the most relevant facts here. What matters is the total Wall Street margin, as that will be the whole cost to the investor to sell illiquid municipal bonds. Nonetheless, I applaud Larry's firm for apparently taking a small part of these total costs.
Lessons you can use
Municipal bonds are perhaps the most illiquid of any major bond asset class. If you think municipal bonds are right for you, I strongly recommend owning them through a very low cost mutual fund which gives you complete liquidity, and avoids these huge spreads altogether. You never know when you might need to sell these bonds so don't buy the the statement that liquidity isn't important.
If you already own the bond, never just put in a market order to sell your bonds. Request bids from your broker, and go to Bondview.com to evaluate the reasonableness of those bids. Bondview.com gives each bond a liquidity rating so you are likely to have thinner margins by selling those with the highest liquidity rating.
Kane recommends establishing accounts at more than one bond broker. That way, you can have multiple brokers working for the best bid, and you can transfer the bond to the broker who executes the sale before settlement date. And don't just accept one bid. Have the brokerage firm go back and make a counter-offer price.
To those brokers who still claim total margins of less than one percent, Bondview.com provides the perfect vehicle to substantiate that claim. Swiping a line from "Jerry McGuire," show me the money!