4 Reasons to Worry About Municipal Bonds
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Reuters
August 7, 2012

Given the recent scandal over Libor pricing, it's easy to think that municipal bond markets may be the next to be outed for pricing irregularities.

While you shouldn't worry about the majority of high-rated municipal bonds defaulting, there are some serious issues about opaque pricing and dealer profits in this nearly $4 trillion market. If you're in the game, you may not be getting the best deal. There's also a cause for concern as high-profile municipal bankruptcies are still occurring four years after the housing meltdown. The California city of San Bernardino was the most recent bankruptcy in the Golden State, following two others that filed in the past two months.

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In reviewing muni regulation recently, the U.S. Securities and Exchange Commission last week criticized the municipal market, citing its illiquidity and lack of transparent pricing information and indexes for market data, including those prepared by Thomson Reuters (the company is working with the SEC and Municipal Securities Rulemaking Board, or MSRB).

Municipal bonds are not regulated the same way as stocks and mutual- and exchange-traded funds and don't have the same rigorous disclosure. They are mainly under the purview of the MSRB, a self-regulator, which is now reviewing the SEC's findings. More investor protection is needed. Here are some items worth discussing with your broker or adviser when buying muni bonds:

1. How much is the bond really costing you?

A broker or adviser "marks up" a bond from the market price to cover their commission. This is not always fully disclosed. Lou Straney, a litigation consultant who represents investors, says he's seen mark-ups as high as 3 percent to 5 percent. The SEC study cited research that found average spreads for muni bond trades to be almost 2 percent for municipal bonds, compared to 1.24 percent for corporate bonds and 0.4 percent for stocks.

Robert Stammers, a chartered financial analyst and director of investor education for the CFA Institute, said industry rules "permit sellers to mark up their bonds for investors up to 5 percent, although 1 percent to 2 percent is closer to the norm." Considering that you can buy a brand-name portfolio of municipal bonds (see below) through an exchange-traded fund for 0.35 percent annually plus a small brokerage commission, any markup above that can seem excessive, so be sure to ask and shop around.

2. What kind of bond are you buying?

General-obligation bonds are the most common, but there are also non-public "conduit" bonds that raise money for healthcare and sports facilities. They may not be covered by the municipalities issuing them, and so may be at much higher risk for default. Be careful.

3. Are you getting the right information?

The SEC found that the secondary market for munis was "relatively opaque." You need solid information on the likelihood of default and the underlying credit of the issuer. Some information is available from the MSRB's EMMA system, but it's helpful if the firm you're buying the bond from regularly researches the bonds it sells and updates you. You also need to know about call features - an issuer can call back the bond and you can lose principal - and how you could resell the bond.

Also, there may be no viable secondary market for many bonds and trading firms may have conflicts of interest. Does the issuer use derivatives? Are you buying a variable-rate bond, which may be riskier than a fixed-rate issue? Also ask about "debt-service coverage," which shows the issuer's ability to cover future bond payments.

4. Are you getting quality default-risk information?

Generally, the highest-rated bonds are at low risk for default. Although yields are much higher, when you get below investment grade, you're rolling the dice. Last year saw $1.06 billion in defaults, which was down about 61 percent from the previous year. In the wake of the 2008 meltdown, by comparison, 194 issuers defaulted on almost $7 billion in bonds. As public agencies gradually recover from the recession, they are able to get their fiscal houses in order, but areas still struggling with the housing crisis are still going to get pinched by lower tax revenues.

Transparency is essential since the risk of default and overpricing doesn't always stick out like a sore thumb. "On the secondary market, there's no public access to pricing," Stammers added, "Most of the information is coming off of systems held by the broker-dealers."

As an investor, you'll be offered a daunting amount of information and your eyes may glaze over when looking at a prospectus. Find an adviser, such as a certified financial planner or chartered financial analyst, who regularly buys munis to tell you what you need to know. If you don't want to buy individual bonds, but still need the tax-exempt income they provide, consider an exchange-traded fund like the PIMCO Intermediate Bond Strategy fund or PowerShares Insured National Municipal bond portfolio, which invest in a basket of bonds.

(The author is a Reuters columnist and the opinions expressed are his own.)