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    Cutting Through the Bond Market Fog When Shopping for Munis

    by Annette Thau

    Cutting Through The Bond Market Fog When Shopping For Munis Splash image

    Are you trying to buy or sell municipal bonds?

    If so, you may need some help cutting through the fog of bond market pricing and trading. Shopping for bonds is not nearly as clear-cut as shopping for individual stocks.

    To help put it into focus, this article discusses how to shop for municipal bonds, using the Internet both as a source of bonds for purchase, as well as for information. The focus is on pricing and comparison shopping.

    Stock vs. Bonds

    If you have bought or sold individual stocks on-line, you may think that buying municipal bonds on-line would be similar. While some Web sites still require you to call a broker to actually place an order for municipal bonds, others now allow you to complete the transaction on-line, without speaking to a broker.

    But it would be a mistake to assume that buying municipal bonds is similar to buying stocks, on-line or anywhere else.

    Over the past decade, there have been enormous changes in the way stocks trade: commissions have been deregulated and the advent of discount brokers has made it possible for individual investors to buy or to sell large quantities of stocks for minute commission amounts. And the Internet has brought individual investors access to information and real-time trading data available years ago only to institutional investors.

    The municipal bond market, on the other hand, continues to be much more “opaque” than the stock market. As in the past, commissions continue to be much larger than those on stocks and to vary from broker to broker.

    My initial assumption was that, since the Web is highly visible and public, all Web sites offering municipal bonds for sale would be pretty much alike. But to check this out, I conducted a simulated search on the Web for a couple of weeks. In order to compare pricing, I narrowed my search to a small sample of bonds: New Jersey bonds maturing in 10 to 15 years. I searched the Web sites of five brokers, chosen because they represent different types of brokerage firms that offer municipal bonds: One nationally known discount broker which sells a wide variety of securities; two mutual fund firms with affiliated discount brokerage firms; and two brokerage firms specializing in bonds (one that sells all types of bonds, and one that sells only municipal bonds).

    I conducted this search over a period of a couple of weeks, to make sure that what I found was not just a fluke. While conducting these searches, I talked to brokers at these and other firms.

    The results of this search shocked me. It seems that, as in the past, pricing varies widely from broker to broker, even on the Web.

    This article will first discuss some of the changes that, have taken place in the municipal bond market, which affect how municipal bonds trade and how they are priced.

    It will then turn to a discussion of Web sites offering munis for sale, as well as the information available on Investinginbonds.com (see article on page 10).

    Finally, it will make a number of suggestions about how to use this information in order to buy bonds that are priced fairly.

    The Secondary Muni Market

    At issue, on the day they are first brought to market, bonds are said to trade in the primary market. All subsequent trades take place in what is called the secondary market. All bonds sold in the secondary market are “pre-owned.” This discussion applies to the secondary market.

    In a number of significant aspects, the municipal bond market of today has changed very little from what it was in the past.

    First of all, the municipal bond market continues to be a vast and very complex over-the-counter market. The backbone of this market is the dealers who buy and sell municipal bonds: These dealers buy bonds to resell at a profit. They put their own capital at risk since if they buy too high, or if the market goes against them, they lose money. How much profit they realize depends partly on the markups they charge, but also on how skillfully they compete with other dealers both in the prices they pay to buy bonds and in how they price bonds for resale.

    Second, commissions continue to be “opaque.” What that means is that the price of a municipal bond is quoted net of the spread, which is the difference between the price the dealer paid when purchasing the bond, and the price you pay when you buy a bond.

    These markups, moreover, continue to be substantial. The only guideline of the Municipal Securities Rulemaking Board (MSRB) is that the spread should be “fair and reasonable,” terms that have never been defined. Typical markups range from roughly ½ of 1% on high-quality bonds with very short maturities to as much as 4% on speculative, illiquid issues.

    Translating these percentages into dollars makes it clear just how large these markups are, compared to commissions incurred when you buy stocks: on a $50,000 lot (a typical size lot in the municipal bond market), a 1% markup is $500; a 2% markup is $1,000 and a 4% markup is $2,000.

    In the late 1980s, markups differed significantly from broker to broker even for the same bonds, and truly abusive markups were not uncommon. The only source of pricing information was the Blue List, which was published daily and listed the bonds that brokers wanted to sell as well as their asking price. But there was no way for individual investors to know what bonds actually sold for or if they were getting a fair deal.

    The first significant change occurred five years ago, when the MSRB began to publish actual trades on the Investinginbonds.com Web site (for a complete description of this indispensable resource, see “A Truly Useful Web Site,” on page 10). Initially, only prices of bonds that traded at least four times in one day were posted, with a lag of one day. This was expanded to include all municipal bond trades, and in 2005, finally, trades began to be posted in real time (almost), with a 15-minute lag.

    The second major change is the advent of electronic, Internet-based platforms, which have replaced the now defunct Blue List. These platforms list bonds that dealers want to sell and the price at which they would like to sell them.

    But the platforms differ significantly from the Blue List. First of all, there are many competing platforms. Currently, the largest is Bond Desk; smaller platforms include MuniBond and ValuBond, but there are dozens of platforms and the numbers are constantly changing. These platforms are not directly available to the public, but rather are marketed to brokers, who publish a list of the bonds supplied to them by the electronic platforms on their own Web sites. In so doing, the brokers are basically acting as intermediaries, in what is essentially for them a “riskless” principal transaction.

    When you as a customer place an order for a bond, these brokers will buy the bond from whoever owns it and resell it to you. They usually add a small per bond fee for this service (typically from $1.50 to $5 per bond, depending on the firm and the size of the order). This is identified as the commission. But remember that the dealer has marked up the bond before posting it on the electronic platform, and that “spread” is not quoted.

    Buying Munis on the Internet

    Let’s assume that you want to buy some municipal bonds, and you decide to search on-line. How should you proceed?

    My assumption is that you are not interested in looking at the thousands of bonds that trade daily. Rather, you have probably decided before going on-line your basic parameters: You want to buy bonds from the state in which you reside (so that you do not have to pay state taxes), and you probably have determined several other criteria, chiefly maturity and credit quality. Presumably, you are going on-line to select bonds that are attractively priced from among the bonds that fit your criteria.

    Figure 1.
    Example of a Typical
    Muni Bond Listing
    From a Bond Search
    CLICK ON IMAGE TO
    SEE FULL SIZE.
    Typically, after you log on to an on-line broker offering municipal bonds, you will be asked to type in a number of criteria: state, credit quality, maturity and so on. The search would produce a list of bonds, typically in table form, such as the listing in Figure 1.

    Some terms are self-explanatory, but note in particular:

    • Quantity: The total number of bonds for sale for that particular issue.

    • The minimum number of bonds per order.

    • The dealer price (the price posted by the dealer selling the bond).

    • The dealer yield should be the yield to maturity (YTM) that would result if the bond is bought at the exact price posted by the dealer. However, other yields may be listed. For more on this, see “A Yield Review” box below.

      Note that the final yield to maturity will be somewhat lower than the “dealer” yield after you add the per bond charge added by the broker through whom you are buying the bond. (Some Web sites identify this markup as the “commission,” and it ranges between $1.50 and $5.00 per bond).

    On most Web sites, you can proceed further: By clicking on individual issues by name, you will obtain more complete information—call provisions, dates of coupon payments, accrued interest, commission per bond and so on.

    While that basic sketch applies to most Web sites showing municipal bonds for sale, there are also lots of differences.

    First, some Web sites are well designed. These make it easy for you to define your criteria and limit your search; and they supply complete and excellent information on any issue that interests you by clicking on second and third levels of data. Some even include technical information on any bond such as duration. More poorly designed Web sites, however, limit you to the first level and offer only very sketchy information about individual issues.

    Also, Web sites differ significantly in the number of choices that come up after you type in your criteria. One firm, for example, applies proprietary screens that severely limit selection. Sometimes, after I typed in my criteria, absolutely no bonds showed up, or perhaps one or two; whereas, with the same criteria, between 20 and 80 would be offered by two other firms, and hundreds by a fourth firm. Too many is as great a problem as too few: The eyes of the reader just glaze over.

    More surprisingly, perhaps, on some Web sites it is very clear that the list of bonds offered for sale comes from an electronic platform. The name of the platform (for example, Bond Desk, ValuBond, or MuniBond) appears somewhere on every page. That tells you that the broker is acting as an agent for a dealer, but does not own any of the bonds listed on its Web site. But, at least on the Web sites I saw, that was an exception and not the rule. One brokerage firm, for example, uses several electronic platforms, and also sells bonds out of its own inventory. But you cannot tell by looking at the Web site which is which. Another brokerage Web site sells only bonds that it owns, out of its own inventory, but again, that information is not on the Web site (I phoned and asked).

    The shockeroo, however, was that identical bonds appeared on different Web sites at different prices. Supposedly, when a broker uses an electronic platform, the price you see listed on the broker’s Web site is the price posted by the dealer selling the bond. So you would expect that two brokers using the same electronic platform would offer the same bond at identical prices.

    Occasionally identical bonds were posted on different Web sites at the same dealer prices. But those same bonds were marked up by one or two points by another broker, and between one and four points by still another broker. (I checked CUSIP numbers to make sure they were identical bonds, and not different pieces of the same issue with, for example, different maturity dates or call provisions.)

    What emerged were patterns of pricing that differed markedly from broker to broker. So the same bond would be offered, say, for:

    • 101 by two firms;
    • 103 by another firm; and
    • 103 to105 by still another firm.

    In other words, some brokers added a second significant markup to the dealer markup, but that was not divulged.

    Bond Desk sent me some literature about their electronic platform, which prominently featured their ability to customize their platform for any client (i.e., brokerage firm) that uses it. I initially thought that applied mainly to the format, but clearly it also applies to price.

       A Yield Review
    All Web sites offering bonds for sale list something under the heading ‘Yield.’ The assumption is that the yield listed first would be the yield to maturity (YTM). What may be confusing is that other yields may be listed in addition to the YTM, and sometimes instead of the YTM. But on some websites, the initial listing does not identify clearly which yield is listed.

    First, briefly, let’s review some of the terms for yield that you may encounter:

    • Yield to Maturity (YTM) is the total return you would earn under certain conditions: if the bond is redeemed on its stated maturity date; if all dividends have been reinvested; and if they have been reinvested at the yield to maturity rate.

    • Yield to Call (YTC) is similar to YTM but it is the total return you would earn if the bond is called at the first call date.

    • Yield to Worst (YTW) is similar to YTM but it is the lowest possible return you would earn if the worst case scenario occurs (sometimes that is the YTM; and sometimes the YTC).

    To illustrate, take a look back at Figure 1, under Dealer Yield. The yield listed on the first line is the YTM. But the footnote labels the yields listed for certain subsequent bonds as the Yield to Call. On this particular Web site, when you click on individual issues, the YTM is listed on the second level. But on other Web sites, there may be no way to determine the YTM. You would need to talk to a broker.

    Why is YTM so important?

    I was told by one extremely experienced dealer that some investors focus not on the YTM but rather on the price to determine which bond is the best buy. But this is a mistake. Let’s again illustrate with Figure 1.

    In that figure, an investor focusing on price might assume that bonds priced at 99 and 102 represent better buys than the bond priced at 106. But those prices are not comparable because, although the maturities are similar, other factors—including the coupons—are not. The YTM takes all of a bond’s cash flows into consideration and enables investors to make apples-to-apples comparisons of bonds with different coupons, maturities and call dates. For more on yield, see my article “Bond Basics: An Investor’s Guide to the Many Meanings of Yield,” in the January 2002 issue of the AAII Journal.

    How to Shop for Price

    If you are shopping for municipal bonds, how can you tell if a bond is fairly priced, or identify good values, without driving yourself crazy looking at 10 different Web sites to determine who has the best prices?

    1) Focus on Yield to Maturity
    If you are looking at a list of bonds that meet your criteria for maturity and credit quality, you should focus on yield to maturity (YTM) to pick the better buys.

    Simply put, among a list of comparable bonds—that is, bonds from the same state, maturing on the same date, and with the same credit quality—the bond with the highest yield to maturity is the best buy. The yield to maturity takes all of a bond’s cash flows into consideration and enables investors to compare bonds with different coupons, maturities and call dates. [See “A Yield Review” for more on yield to maturity and other yields.]

    When comparing yields to maturity, make sure the bonds are comparable. As a first cut, to be comparable, bonds must have the same maturity date (or very close), the same credit quality, and must be from the same state. But be aware that is a first cut. Bond pricing is subject to a lot of nuances. For example, is the bond rated AAA simply because it is insured or because the municipality is financially secure? Is it a revenue bond or a general obligation (GO)? Other nuances can also affect the quoted bond price, including the size of the bond trade and whether it is a customer sell or a customer buy.

    Finally, if a bond is priced at a premium (above 100) and subject to call, compare the yield to maturity of the bond to the yield to maturity of bonds maturing at the same time as the first call date. The yield to the first call date should be higher.

    2) Check Out Interest Rates Offered by the Broker Web Site
    Similarly, if you want to determine whether the Web site of a broker lists bonds at prices that are in line with the market, look at the yield to maturity of a few bonds at certain key maturities (for example, five years or 10 years) and compare the yield to maturity of those bonds to a few comparable bonds on the Investinginbonds Web site. If the yields to maturity are consistently lower (say by ¼% or ½%), that is a sign that markups are likely to be high—perhaps two to five points ($20 to $40 per bond, depending on maturity and credit quality) higher than the market. That would be a signal to be prepared to bargain, or to look elsewhere.

    3) Check the Trading History of a Bond Before Buying
    Suppose you are offered a bond by a broker, or that you think a particular bond represents an attractive buy. How do you determine if the bond is priced fairly?

    The easiest thing to do before buying any bond is look up its recent trading history. (One brokerage Web site actually has links to recent trades.) Remember that trades occur at different prices. If your bond traded recently, check whether the prices are customer buys or customer sells, or interdealer trades. Generally, the lowest prices are the customer sells, the highest are the customer buys, and the middle ones are the interdealer trades.

    Clearly, if several prices are shown for customer buys, you would want to buy at the lowest customer buy price you see. But it is sometimes possible to do better. Individual investors can sometimes buy at the same price point as interdealer prices. Yes, I know, you are not a dealer. But, surprisingly, I saw a number of bonds offered for sale to individual investors at, or even sometimes a bit less than, recent interdealer prices. Those prices were at times lower (by two or three points, $20 or $30 per bond) than recent customer buys.

    On the other hand, if your bond has not traded within the last two or three days, then the prices listed in its trading history may be stale, and no longer relevant. Remember that many bonds trade infrequently. In that case, you need to look at the price histories of comparable bonds. Also, if interest rates have moved significantly during a period of a few days, that has to be taken into account.

    4) Talk to a Broker
    Even if you are logging on to a Web site that allows you to complete the purchase of a municipal bond on-line, do not complete the purchase without talking to a broker. This was one of the most surprising findings of this whole exercise. But it became clear as I spoke to brokers that you gain nothing by completing the trade on-line, for several different reasons:

    • First, before buying any bond, you need to double-check a lot of details including accrued interest, call provisions or sinking fund provisions. At worst, many listings are incomplete, or contain errors. Many listings are confusing, with some key features of the bond not clearly stated on the Web site. Any honest broker will be willing to double-check all the features of a bond that ultimately affect return.

    • Second, all brokers have access to pricing data that includes a “fair value” for any bond. Within the recent past, there has been increasing emphasis on due diligence requirements and brokers are conscious that the NASD is cracking down on abusive practices. One broker indicated that the house policy of his firm requires brokers to check “fair value” and prohibits them from selling a bond at a price that is outside of a 3% pricing band. While even that seems fairly wide, it is useful to check pricing against fair value, as well as the house policy. Also, some electronic platforms indicate to brokers whether the listed price is firm or whether there is room for bargaining. Again, you would want to check that out.

    • Third (and this grew out of a conversation with a senior marketing person at the firm with the highest markups), firms expect you to call and they expect you to bargain. The firm does not expect that you will pay the listed price. In fact, for the firm I called, and for some of the more poorly designed Web sites, it became clear that the Web site simply represents a way to get you to pick up the phone and talk to a broker. It is a way of getting you into the store. When you talk to a broker, that broker knows if the markup is excessive. To make the sale, the broker can use a number of tactics. He (or she) may offer to try to buy the bond at a more attractive price—he knows he can—to make you feel as if you are getting a bargain. Or, he may steer you to a bond in the firm’s inventory as opposed to one listed by a dealer on an electronic platform—and again, with better pricing. But if you complete the transaction on-line, without talking to a broker, you will have overpaid. That is analogous to going into a car dealer’s showroom and paying the listed price.

    Conclusion

    For this article, I compared municipal bond pricing on several brokerage Web sites. I did not attempt to contact brokers without Internet sites, to see how their prices compared. But my guess would be that the type of pricing discrepancies found on the Internet are representative of what is going on in the industry as a whole—as in the past, prices of the same bond continue to vary from broker to broker.

    One year ago, I wrote about the arrival of real-time pricing on the Internet (“Muni Trading Gets Real: Current Prices on the Internet,” May 2005 AAII Journal; available at AAII.com), and I asked whether posting prices in real time has affected pricing significantly. Clearly, the answer one year later is: not much.

    However, my research did reveal the answers to two important questions for municipal bond buyers:

    1. Do you get a better deal from discount brokers? Sometimes you may, but not always. As we saw, some discount brokers use electronic platforms but these are customized and the dealer prices listed vary from broker to broker.

    2. Do you get a better deal by buying only bonds that firms own in their own inventory? Not necessarily. Dealer prices vary based on a number of factors: The skill of the trading desk in bidding for bonds at low prices; the commission structure within the firm (if the firm has a trading desk, markups are split between brokers dealing with individual customers; and the trading desk); and finally, how much the dealer wants to earn on any one bond.

    What is evident is that, while horribly abusive markups are not as rampant as they once were, markups continue to differ significantly from broker to broker, and in spite of the fact that trade prices are published, markups continue to be large and opaque.

    Perhaps one reason why pricing practices have been so slow to change is that, according to most of the brokers I spoke with, the great majority of individual investors remain unaware that pricing information is available on the Investinginbonds Web site.

    There is also no information available concerning the percentage of bonds sold through electronic platforms rather than through brokers interacting with customers on a personal basis. One estimate from a knowledgeable dealer was that approximately 20% of bonds that trade on a daily basis are listed on electronic platforms, which means that 80% of muni bonds are sold in the same way they have always been: through dealers and brokers interacting with large institutions and individual investors.

    Perhaps you are still buying bonds the old fashioned way, by dealing with a broker you know, and trust, and who specializes in municipal bonds.

    Surprisingly, even in the age of the Internet, that may still be your best source for buying bonds. If you are dealing with a broker who is a specialist in this market, that broker can point you to bonds that are not only priced fairly (good values in the current market), but also appropriate to your needs, your risk tolerance and your portfolio.

    But if the bonds offered on publicly viewed Web sites differ so widely in price, it is safe to assume that those offered by brokers selling person-to-person differ equally widely from firm to firm. So I would use the Reagan slogan: Trust, but verify.

    Hopefully, reading this article will have given you some pointers in that direction.

       A Truly Useful Web Site: Investinginbonds.com
    Investinginbonds.com has become an indispensable resource for buyers of municipal bonds.

    In addition to publishing actual bond trades, it publishes a daily chart of the current shape of the yield curve in the municipal bond market, as well as a table showing current aggregate yield levels for municipal bonds across different credit ratings. Since the information in the financial pages of most newspapers is so poor, anyone shopping for municipal bonds should start here (see Figure 2).

     

    What you want to click on is Municipal Market at a Glance. The first thing you will see is a graph of the current yield curve in the municipal bond market (our example in the graph on the left in Figure 2 dates from April 5). Note that while the Treasury yield curve is flat to slightly inverted, with short maturities yielding basically as much as long maturities, the yield curve in the municipal bond market remains upward sloping, with about 100 basis points difference between long maturities and short maturities. That tells you that by going out to longer maturities, you will pick up yield. If you click on the See Data link under the graph, you will see a newly expanded table (on the right in Figure 2) showing aggregate yields from three months to 30 years, across credit qualities. While the yields of individual bonds will vary somewhat from these, this is a good starting point.

    The most useful data, of course, are the details of actual trades. All trades are reported separately, but the format allows you to click on trades that occurred the day you are looking, as well as on a full history.

    Figure 3 shows trades that occurred over a period of a little less than a week for a tobacco bond. Trades are identified as “purchase from customer” (an investor selling a bond to a dealer), “inter-dealer” trade (one dealer selling to another), or “sale to customer” (an investor buying a bond).

     

    The spread can easily be calculated by subtracting the lowest price (a customer selling to a dealer), from the highest price paid by a customer buying the bonds. In this case, the spread is wide: The lowest customer sell is 106.7 and the highest price paid by someone purchasing the bond is 114.2 (two separate buys), with interdealer trades hovering around 109 and 110. But note that customers sold bonds at different prices, ranging from 106.7 to 111.8, and customers bought the same bond at prices ranging from 110.7 (very close to the dealer price) to 114.2. Tobacco bonds are technically the lowest investment grade, but are considered more speculative. That is one explanation for the wide spreads, in spite of the fact that this is an actively traded bond.

    Bonds with higher credit quality usually trade with narrower spreads, within bands of two to four points.

    You can also get the complete trading history of a bond. When consulting a bond’s trading history, be sure to check the dates of the listed trades. Many bonds do not trade daily. So if the last trade of a bond occurred more than a few days earlier, the price may be stale.

       For More Information
    Read these past AAII Journal columns by Annette Thau for more on the basics of municipal bond investing:

    Also, see the Investor Classroom area for a series of articles that introduces you to bond terminology:


    Annette Thau, Ph.D., is author of “The Bond Book: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More,” (copyright 2001, published by McGraw-Hill; $29.95). She has spoken to AAII chapters in different parts of the country about bonds and bond funds.

    Ms. Thau is a former municipal bond analyst for Chase Manhattan Bank. She also until recently was a visiting scholar at the Columbia University Graduate School of Business.

    While writing this article, Ms. Thau interviewed a lot of people in the industry. In particular, she would like to thank Fred Stoever, principal in the firm of Stoever Glass, and Kevin Olson, the creator of Municipalbonds.com, which flags abusive pricing, for sharing some of their insights about municipal bond pricing.


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