Muni Bonds Draw Investors But Come With Serious Risks

With many municipalities exhibiting better financial health and tax-free bonds touting pretty good returns, municipal bonds are attracting investors. However, this doesn’t mean that you, as a prospective investor, shouldn’t approach munis with caution.

Investors don’t pay a commission when they purchase a municipal bond, but they do have to pay a “markup,” which is the difference between the price paid and the broker’s cost. Unfortunately, many brokers don’t tell customers about this markup, instead focusing on the benefits of yield rather than disclosing more about the price. Because of this, most retail investors don’t know how much these trades are costing them in charges. You should know that these markups can be pretty high.

The Wall Street Journal reports that according to a study from research firm Securities Litigation and Consulting Group, out of one in 20 trades, investors that purchased $250,000 or less in municipal bonds paid a 3.04% markup or greater, which, at today’s rates, is one year’s worth of interest income (compare that to the under $10 in commission investors pay when purchasing stock from the majority of online brokers-.004% interest on $250,000; meantime, management fees for mutual funds are approximately 1% yearly. The study examined close to 14 million trades involving long-term, fixed-rate munis between April ’05 to April ’13.

The WSJ article goes on to note that the research firm’s founder, Craig McCann, says that since 2005, investors collectively have paid at least $14 billion in what he believes are excessive markups, which is at least two times the normal cost to trade a bond. He translates that to over 1 billion dollars “needlessly transferred” to dealers.

While brokers are right in that it can be very hard to find any certain trade on any day, federal rules mandate that markups must be “fair and reasonable.” Still, how this is defined lacks specificity.

Municipal Bonds
Munis are debt securities. Cities, states, counties, and other government entities issue them. Municipal bonds are used to fund daily obligations and pay for capital projects, including highways, schools, or sewer systems.

When an investor buys a municipal bond, that party is lending money to the bond issuer in return for regular interest payments and the return of principal. A municipal bond may not mature for years. However, short-term bonds do generally mature in one to three years.

The risks involved in investing in municipal bonds include call risk, credit risk, interest rate risk, and inflation risk. In addition to broker markups, investors should also know about the tax implications that may be involved, including certain taxes and benefits. You should also make sure that the person you buy the muni through is properly licensed and registered either with FINRA, a state securities regulator, or FINRA.

At Shepherd Smith Edwards and Kantas, LTD, LLP, our securities lawyers represent investors that have lost money due to municipal bond fraud.

Municipal Bonds
What’s Eating Your Munis?, The Wall Street Journal, June 7, 2013

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