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Municipal Bonds and the Industry's Dirty Little Secret

Muni bonds are constantly being pitched as safe and liquid. Recent articles dispel the myth that they are safe as nearly every city is facing budget woes. But it's the fact that they are being pitched as liquid that could be the financial industry's biggest dirty secret.

Just how liquid are municipal bonds?
Investopedia provides a standard definition of liquidity:

"An asset that can be converted into cash quickly and with minimal impact to the price received."

I have no disagreement applying this liquidity definition to muni's as far as being quickly converted to cash. It's the second aspect, that they can be sold "with minimal impact to the price received," that gives me pause and that Wall Street doesn't want you to know about.

Among brokers and planners, word has it that these bonds can be sold for $25 to $100 each. True, but only partly so. The part they are not telling you is that the price you sell it for can be two percent to five percent more than the price a brokerage firm will ultimately sell it to another investor. To frame it properly, your cost to sell a muni bond can be:

  • Roughly half to a full year's interest on those bonds.
  • Roughly half to the full cost to sell your house with all of those commission and junk fees.
The real estate and mortgage industries are on the dirty side as well, yet they at least disclose the total fees you are paying when you sell your house. With municipal bonds, you are only told the commission costs which can amount to less than five percent of your total costs.

A glimpse into darkness
It was once impossible to see the spreads investors were paying to buy and sell muni bonds. Fortunately, the Municipal Securities Rulemaking Board has now implemented a web site known as EMMA (Electronic Municipal Market Access) that allows you to track activity. You enter in the bond's CUSIP number and you can see dates and prices bonds were sold and purchased.

While no longer impossible to look at spreads, it is virtually rocket science to analyze. Typically, the bond is sold through an "interdealer-trade," meaning that a bond dealer buys it. That dealer then either sells it to another dealer or outright to another investor. This process can take days, and the ultimate selling price is impacted by more than the spread. Changes in interest rates and even credit quality can be a large part of this difference.

Other ways to own Munis
By buying munis in open-ended mutual funds, one can avoid the high costs of liquidating the securities as funds can be sold at Net Asset Value (NAV). Investors can avoid the high spreads of buying and selling them on the secondary markets. You can get professional management, sporting fees as low as 0.20% annually, with the Vanguard Intermediate-Term Tax-Exempt Bond Fund (VWITX).
There is a third way of owning muni bonds known as separately managed accounts (SMAs). Usually sold through brokers, a third party money manager builds and maintains the portfolio for each investor, rather than being pooled together, as is the case in mutual funds. Lord Abbett is one such manager of muni bonds, including in SMAs. I spoke with Daniel Solender, partner and director of municipal bonds at Lord Abbett, to better understand liquidity issues of muni bonds in SMAs.

Solender noted Lord Abbett can purchase muni bonds in larger quantities much more efficiently than most investors can do individually. If the investor sells, however, they can look at several avenues to liquidate, but large spreads do exist. He noted that owning munis through mutual funds, or holding until maturity, were the only way to avoid large spreads.

My advice
Munis are far from risk-free, and owning them directly or through SMAs results in unacceptable liquidity. Before considering munis, start by building your fixed income portfolio with taxable bonds backed by the US government and locate those bonds in your tax-deferred portfolio. Then consider munis, but only through a low cost mutual fund or ETF. Don't let anyone tell you that you are avoiding the risk of changing rates by holding the bonds to maturity. And never hold muni bonds directly, even through an SMA. The industry's dirty little secret will rob you blind.

I've heard many financial firms claim that their bond desk can sell munis for less than one percent. Yet when I push for more details, the conversation always seems to come to an abrupt end.

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