Radical Guide to Bonds: A Quick Introduction to the Municipal Bond Market
At the heart of the municipal bond market is a tax shelter. The federal government exempts nearly all municipal bonds from federal interest income taxes. Sweetening this benefit, many state governments offer an exemption from state income taxes, too. (The state tax exemptions flow to resident investors who purchase municipal bonds issued within the state).
Having this “most favored” tax status, municipal bonds lead all other retail bond markets in popularity. These bonds increasingly find a home among tax-sensitive, buy-and-hold, affluent, and retired investors. Said differently, the municipal bond market matters to many small retail investors.
One statistic describes the typical municipal bond investor profile. According to a Securities and Exchange Commission (SEC) study, the five largest state issuers of municipal bonds are also the five states with the largest populations over 65 years of age --- California, New York, Texas, Florida, and Pennsylvania. It should be no surprise, too, that these five states are among the wealthiest states in the U.S.
Still, the municipal bond market is the worst offender for opacity, confusion and cost among all retail bond markets. Price quotes do not regularly exist. Only one-in-three municipal bonds trades in any year. An investor usually buys a bond as the last link in the chain of brokers, broker’s brokers, and one or more dealers. All these middlemen incrementally add their costs to the trade.
If you want to know more about the granularity of the municipal bond market, check out the SEC study (July 2004) found on its website. (See Sources). The study is excellent. The study clearly depicts the transaction chains for both retail and institutional investors. Here are a few of its takeaway points:
- Small, retail trades cost more than institutional trades. Like most markets, institutional customers have leverage; trading size does matter. In the municipal bond market, however, the spread --- or the difference between the customer’s price and the dealer’s cost ---is outsized. For example, the median spread for a retail-sized trade of $25,000 or less is 2.23% of principal. For institutional-sized trades of $1 million or more, the median spread drops to .10%. So the retail investor pays about 15- 20 times more for a trade than an institutional investor pays.
- Dealers own the market. Of the 1,600 municipal dealers, 13 dealers handle about 75% of all trading flows to customers.
- Prices for the same bond vary from dealer to dealer. We like this analysis. The study looked at the trade reports (provided through the Municipal Securities Rulemaking Board (“MSRB”)) for identical bonds traded in the same amount and on the same day. For identical trades of $10,000, only 17% of the dealers quoted identical bid prices to customers. For identical trades over $1 million, 50% of the dealers quoted identical bid prices. It would be hard to argue that intra-day market movements explain these price differences.
- You may not escape paying taxes. You can’t ignore it, but the Alternative Minimum Tax (“AMT”) is out there. AMT is a parallel tax system; it ensures that investors with significant deductions end up paying a minimum amount of taxes. The AMT adds back items that would, otherwise, be straightforward deductions for you. You lose these deductions and pay more in taxes.
Sadly, the interest income on tax-exempt municipal private-purpose bonds is not deductible under AMT. While AMT municipal bonds may offer 20 to 30 basis points more in yield to compensate you for their taxability, you will still be facing 25-28% tax rates for these bonds under AMT.
We have to take the largely untraded municipal bond market as it is --- concentrated in a few dealer hands with few or any price quotes. That said, this is a market with much appeal for the retail investor. As an accessible tax shelter, it works beautifully. For the buy-and-hold investor, it is almost an obligatory investment.
We will discuss low-cost trading strategies to help you. That will come later. As you’ll see, we unabashedly advocate using online bond trading, MSRB trade reports, and, where accessible, new issue programs.
Now we will turn briefly to the funds side of the municipal bond market.
June 3, 2005 | Permalink
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