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Muni Charges Eat Up Interest as Yields at 40-Year Low

Investor Peter Kuhn
Investor Peter Kuhn sits for a photo at the computer at his office in his home. Photographer: Tony Avelar/Bloomberg

Peter Kuhn, an investor from San Jose, California, who owns more than $1 million in municipal bonds, scours pricing websites and uses Zions Bancorporation’s online brokerage to avoid getting overcharged when he buys tax-exempt debt.

Consumers who aren’t as savvy may be paying more than they have to for state and local obligations in the $2.8 trillion U.S. municipal market, where individuals and mutual funds hold about two-thirds of outstanding securities. Firms selling to customers mark up the price an average $5 to $10 per $1,000 bond, or 0.50 percent to 1 percent, said Thomas Doe, chief executive officer of Municipal Market Advisors, a Concord, Massachusetts-based research firm.

Because tax-free yields are at their lowest levels in four decades and dealers have flexibility on pricing, investors have to be more careful to make sure the markup they’re being charged isn’t excessive, said Mitchel Schlesinger, chief investment officer at FBB Capital Partners.

“Do more homework to make sure you’re not getting ripped off,” said Schlesinger, who oversees $80 million in munis for the Bethesda, Maryland-based advisory firm. “You could easily give up a year of coupon income because yields are so low.”

Shrinking Supplies

Shrinking supplies of tax-free municipal debt and the lowest rates on U.S. Treasury 10-year notes in more than a year have driven down yields on 10-year and 30-year AAA general obligation bonds to the lowest levels since the 1960s, according to MMA’s Doe. The 10-year tax-exempt rate was 2.60 percent as of Aug. 24 and the 30-year rate was 4.16 percent, according to MMA’s indexes.

About 2,000 firms from Bank of America Corp.’s Merrill Lynch to New York-based Lebenthal & Co. buy and sell state and local securities to individuals, according to the Municipal Securities Rulemaking Board in Alexandria, Virginia. The obligations aren’t traded on exchanges like stocks. Dealers typically are compensated in lieu of a commission by marking up a bond’s price when selling to customers or marking down when buying, said Ernesto Lanza, general counsel for the MSRB, which sets rules for the industry.

That’s legal as long as the markup or markdown is “fair and reasonable,” according to the MSRB. Brokers consider items including market value, transaction costs, trade size, credit quality and risk involved in owning the bond when deciding the total price charged to the customer, Lanza said.

Using EMMA

Investors can use EMMA, the MSRB’s Electronic Municipal Market Access website, to type in a bond’s serial number, known as a Cusip, and see how a broker’s offering lines up with what other consumers paid. For example, on Aug. 9 a New York City general obligation bond maturing in 2019 traded four times in two hours, according to EMMA. A dealer bought from another firm $35,000 in bonds priced at 110.79 cents on the dollar. The same-size lot was sold to an investor priced at 112.01 and yielding 1.85 percent.

That differential in price eats up almost a year’s worth of income, said Schlesinger.

Another customer buying an $800,000 lot of the bond the same day received a price of 110.51 for a 2.22 percent yield, according to MSRB data.

“It pays to be a savvy investor,” said Bhu Srinivasan, publisher of the research website “If you ask, or you have a relationship with a broker where they know you are an aggressive shopper, you may get a better price.”

Municipal bonds are generally exempt from federal taxes as well as state and local levies for residents in most states where they’re issued. For highest earners paying a 35 percent federal rate on income, a 2.60 percent return on the securities is equivalent to a 4 percent taxable yield.

‘Best Value’

Kuhn, the California investor, looks up recent trades before buying because “you want the best value for your dollar,” he said.

The 49-year-old founder of an employee benefits consulting firm said he purchases munis on The Salt Lake City-based online brokerage charges $10.95 per online trade and doesn’t mark up securities over the price it paid, said Veronica Atkinson, vice president of bond trading for Zions Direct. A dealer may have marked up the bond before it got to the site, she said.

When buying from online brokerage firms, investors should ask if the yield to maturity or yield to the call date of the bond has been calculated with all fees and commissions, said Alexandra Lebenthal, chief executive officer of Lebenthal, which manages about $200 million in municipal accounts.

Price Information

“Recent price information isn’t always available to investors because the industry includes many small issuers whose bonds may not trade often,” said Guy LeBas, chief fixed-income strategist for Janney Montgomery Scott LLC in Philadelphia with $7.3 billion in tax-free bond assets.

Almost all trades of new municipal issues in the secondary market occur within the first 30 days. That’s why investors selling bonds also should watch their pricing because no one may have bought them in more than a year, said Srinivasan.

Consumers can view securities of similar maturity and credit quality on sites such as EMMA if there’s no recent data on the obligation they’re searching for, said Michael Decker, co-head of the municipal securities division at the Securities Industry and Financial Markets Association, a trade group based in New York and Washington.

New Issues

Investors can avoid the varying markups on munis trading in the secondary market by buying new issues during a so-called retail order period when one is offered.

The state of California typically has two days when people can place orders ahead of firms in some debt sales. Consumers and institutions receive the same final price, and individuals may cancel their orders if they don’t like the final cost, said Tom Dresslar, spokesman for California Treasurer Bill Lockyer.

Investors placed early orders for 55 percent of issues sold during California’s $2.5 billion tax-exempt bond sale in March, Dresslar said. While individuals still have to go through a broker, there’s no markup, according to the state’s Buy California Bonds website. Instead, sellers receive a portion of the income derived from the sale of the securities, Dresslar said.

The definition of what’s “fair and reasonable” for markups charged to investors buying in the secondary market has led to complaints brought by individuals and actions by regulators against firms. The Financial Industry Regulatory Authority accepted settlements this year with RBC Capital Markets Corp., a New York-based broker-dealer, and Los Angeles- based Wedbush Securities Inc. Finra, based in Washington, is a non-governmental body overseeing almost 5,000 brokerage firms.

Lawsuit Settled

Both firms resolved the regulatory actions without admitting or denying Finra’s findings, including that RBC unfairly priced six municipal debt transactions in 2007 and Wedbush, five transactions in 2008.

Natalie Taylor, a spokeswoman for Wedbush, and RBC spokesman Kevin Foster both declined to comment in e-mails.

Investors Gene and Patricia Boyce of Raleigh, North Carolina, settled their class-action lawsuit in June with Wachovia Securities LLC, acquired in 2008 by San Francisco-based Wells Fargo & Co., according to court documents.

The complaint said Wachovia offered the Boyces bonds marked up two to almost five times the 50 basis points agreed on. A basis point is 0.01 percentage point.

Wells Fargo declined to comment, spokeswoman Teresa Dougherty said in an e-mail.

Gene Boyce said in a telephone interview that he couldn’t discuss the resolution of the case.

Rising Taxes

“There’s a lot of people like me investing because it’s tax-free, it’s a fairly safe and stable market and you’re virtually guaranteed the coupon rate,” said Boyce, a lawyer.

Munis tend to attract even more investors when taxes are rising, said John Hallacy, a municipal strategist in New York for Bank of America Merrill Lynch. In 2011, federal income tax rates for the highest earners will go to 39.6 percent from 35 percent, unless Congress acts.

The supply of tax-exempt munis has shrunk since Congress established the Build America Bond program last year, giving subsidies to state and local governments issuing taxable debt. Total new issues of tax-exempt debt in the 12 months through July 2010 was $304 billion, down 30 percent from the same period through July 2008, according to MMA’s Doe.

Investors who can’t buy bonds in lots worth $25,000 or more should consider funds for diversity and because smaller issues tend to have larger markups, Janney’s LeBas said.

Expense Ratio

The average expense ratio for a no-load municipal bond fund, or one that doesn’t have an upfront charge, is 0.60 percent, said Miriam Sjoblom, a bond-fund analyst for Morningstar Inc., a Chicago-based research firm.

“When bonds trade, the price isn’t dictated by an omniscient source,” said Josh Gonze, who helps manage $6 billion in municipal bond funds and accounts for Thornburg Investment Management Inc. in Santa Fe, New Mexico.

With yields so low, investors purchasing individual bonds should know how markups work because they’ll “take a relatively bigger chunk from the investor’s total return,” he said.

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