Munis: What's a Fair Price?

Critics say markups are too high. Now regulators are paying attention

When Mary H. Day's broker moved from Olde Discount Brokerage to PaineWebber in 1997, he persuaded the Vienna (Va.) artist to transfer her $2 million municipal-bond portfolio, too. He reasoned that with PaineWebber's strength as a muni underwriter, he could get her better deals than at Olde Discount. The broker returned to Olde Discount a year later, but PaineWebber officials persuaded Day to stick with them. "I was told that because of the size of my account, I was not only going to get the best price but even discounts," says Day, a dedicated muni investor.

By late 2000, Day's relationship with PaineWebber was over. She closed her account in frustration over the poor performance of her portfolio. She says that after comparing her trades with those at other firms the same day, she concluded that markups by PaineWebber were as high as 5%. A BusinessWeek check of a sample of her trades against indicated prices from Bloomberg Financial Markets showed similar discrepancies. Day alleges that the markups cost her more than $180,000. "I feel that I've been unfairly gouged," says Day, who is seeking about $1.1 million in damages through arbitration from PaineWebber, which is now part of UBS Financial Services Inc. UBS spokesman Paul Marrone said Day got "good execution, fair and reasonable prices." After examining the trades, the firm concluded that her claim was "without merit," he added.

The dispute highlights a big problem in the trading of municipal bonds, which are an increasingly popular vehicle for investors seeking an alternative to the low yields on Treasuries. Critics say the market is notorious for wide spreads, or the difference between what brokers pay sellers and charge buyers of the same bond. Regulators have succeeded in squeezing spreads in sales of stocks down to just a few pennies -- to the point where Wall Street dealers complain they aren't making money. But regulators are only now starting to look at a $9.5 billion-a-day muni market in which spreads of 5 cents, 10 cents, and 20 cents on the dollar aren't uncommon.

Although the muni market is far less liquid than the stock market, many institutional investors contend that spreads still shouldn't exceed 1% to 2% for most issues, or $1,000 to $2,000 on a muni sold for $100,000. Yet, resale prices for munis "are probably worse than the secondary market for vacation time shares," contends Kevin Olson, a former muni trader for Bank of America (BAC ) and PaineWebber who now publishes a daily report exposing the muni transactions with the worst spreads on his Web site,

Muni dealers say the problems are vastly overstated. They insist that trades with excessive spreads are no more than a small fraction of the 29,000 daily muni transactions. Besides, they say, it isn't fair to compare the trading costs for munis and stocks, since there's no New York Stock Exchange for munis. Instead, there's a fragmented market comprising some 50,000 government issuers with 2 million different bonds bought and sold by hundreds of dealers across the country.

With many older or more obscure munis trading only sporadically, dealers and even some regulators say it's reasonable to expect investors to take a haircut on bonds that dealers know they'll have a hard time reselling. "What is a fair and reasonable price for [a] New York City [issue] may not be the case for the Opelika [Ala.] schools -- they're not comparable bonds," says Christopher Taylor, executive director of the Municipal Securities Rulemaking Board, the self-regulatory organization in Washington that oversees the muni- bond market.

Critics charge that the problems extend well beyond that. Olson studied 644,000 "markets," each a day's trading in an individual muni issue, last year. In one-quarter, or 162,000, of them, either the spreads were larger than 1%, or the purchase or resale prices fluctuated by more than 4%. That occurred in 99,000 cases in 2001, and 86,000 in 2000.

Some money managers think the situation is getting worse. They say brokers, trying to make up lost income from stock trading, may be exploiting the low yields on taxable Treasury bonds to sneak through higher charges on munis, which are exempt from most income taxes. "When you factor in the tax exemption, munis look cheap compared with Treasuries no matter how much the brokers mark them up," says Ken Woods, an Atlanta money manager who handles $500 million in mostly municipal bonds for private clients.

The trouble might not end there. Many munis have a call feature allowing the issuing state or municipality to pay off the bonds early, often at par, on preset dates. Critics say these are potentially expensive traps for the unwary. The risk is that when buyers pay more than par for callable bonds, the interest they receive won't cover the premium if the bond is called, leaving them out of pocket.

Consider recent trading in bonds issued by the city of Saginaw, Mich., for a local hospital, St. Luke's. The bonds were first sold in 1991 with an interest rate of 6% -- a rate that's hard to find now -- and a maturity of 2021. On June 20, two bonds with a face value of $15,000 were sold, one at $100.25 and the other at $102.25 per $100. But the next par call on these hospital bonds was looming little more than a month away, on July 28 -- meaning that if the hospital chooses to refinance these bonds, the buyers will lose money.

This situation appears to be getting worse, though dealers dispute that. Olson says his analysis of 2002 trading data filed by dealers to the muni board shows that in 1,681 trades, muni bonds were sold to investors at prices that saddled them with a risk of losses -- more than double the 779 such trades in 2001. But dealers say many of these transactions reflect calculated gambles by savvy investors who, in their scramble for higher returns, are betting that the issuer won't call the bonds early. If they guess right, they can earn a much better return than they would otherwise have received on a bond that wasn't about to be called.

Still, the growing worries about how the market works appear to be prodding the muni board into action. On June 13, it said it will clarify rules to ensure "fair pricing" -- but without placing limits on markups, such as the 5% cap that the NASDAQ puts on stock trades. And on June 24, the board began disclosing trades in less-active muni bonds on the following day; previously the information was available only after a week. Taylor says the board is on track to begin real-time reporting of all muni trades by mid-2004, as part of a deal the industry struck with the Securities & Exchange Commission back in 1994.

Such reforms will ripple though the market. Wall Street firms warn that liquidity could dry up in more obscure bonds, but money managers admit that real-time trade disclosures could reduce the opportunities for shrewd traders to make easy money by exploiting price disparities. "I shouldn't be interested in price disclosure because I'm able to buy at good prices," says Thomas J. Fetter, vice-president of municipal investments for Eaton Vance Management, a Boston funds firm. "But price transparency is going to make this market far more efficient. This will be good for everyone." Particularly for the legions of investors who now can only guess whether they're getting a good deal.

By Dean Foust in Atlanta

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