Most investors and stock brokers will tell you that there is very little benefit to having a portfolio of municipal bonds managed by an independent money manager versus a portfolio of stocks. They argue the fees on the managed account charged by the manager will eliminate the advantages of professional management.  Most feel that a laddered portfolio, one in-which a portion of the bonds comes due each year, is the most efficient method of structuring a municipal bond portfolio. 

The more research we do on this subject the more we find that the municipal bond market is a very inefficient market.  By inefficient we mean that the market is subject to price fluctuations.  These price fluctuations allow the sophisticated manager to take advantage of opportunities to create long-term gains in the portfolio in addition to tax-free income. 

THREE CHOICES

Investors desiring to purchase Municipal Bonds have three choices.  The first is to use a broker.  We have found that this is the most popular method, and perhaps the most inefficient. Brokerage houses like Merrill Lynch, Morgan Stanley, and others increase the price of the bond to investors.  While many investors realize that there is a “small mark-up”, a recent court case points out that the normal industry mark-up is anything but small. 

A lawsuit was brought against Merrill Lynch by Stanley Grandon, a Michigan doctor, who claimed that Merrill Lynch concealed the amount it was making on the bonds it sold him in 1994 and 1995.  The ruling, which now extends to all broker-dealers, was issued by the U.S. District Court for the Second Circuit in New York reversed a lower court decision that Merrill Lynch wasn’t required to report its profits from municipal bond sales.  Grandon claims that the Michigan bonds he bought from Merrill Lynch were sold at between 3.7% and 9.8% above the “fair market price.”  Merrill Lynch disputes that saying that the markups were between 2 and 3 percent.  Merrill Lynch spokesman Bill Halldin stated “that the markups were not excessive.” 

While 2% to 3% might not seem excessive to Merrill Lynch it certainly seems excessive to me, especially when the alternative is to have no mark-up on the bonds.

In addition to the markups by the brokerage firm, the broker needs to mark the bond up to make some commissions which are also not disclosed.  We have seen brokers mark up bonds anywhere from .0050 (50 basis points) to 1.00% (100 basis points). 

From the above you can see that municipal bond purchases are very profitable for the brokerage firms and the brokers.  Clients are unaware that they are paying anywhere from 2.5 % to 4% extra on bonds. 

The second option is to invest in a municipal bond fund.  We compiled a search of no-load intermediate and long term municipal bond funds with a minimum initial investment of $100,000 or more.  15 funds cleared the search.

The first item in the funds we analyzed was the expense ratio charged by the fund to the investor.  Of the 15 funds the expense ratios ranged from a low of 0.49% (49 basis points) to a high of 0.77% (77 basis points).  This compares favorably to the expenses charged by separate account managers.  The second item we compared was turnover.  Turnover ranged from a low of 16% per year to a high of 262% per year.  The average turnover of the 15 funds was 48% per year which is high and not tax efficient. After deleting the lowest and highest turnover funds the average drops to 33% which is better, but still not as tax efficient as they should be.  It is important to remember that while the interest on municipal bonds is tax free, the investor can still receive either short-term or long-term gains or losses on the sale of the bonds.  With a mutual fund the investor has no control over these gains, while with an individually designed portfolio the investor can control the gains. 

Finally, we looked at the holdings of the  funds to determine what type of bonds they are investing in for quality and duration.  Of the 15 funds all but one had an average weighted price of more than 101.5.  This means that they are striving for yield (income) and not worried about total return.  It also means that the bonds purchased may mature at a price lower than what the manager paid, causing a long-term loss. 

THE BEST OPTION BY FAR!

The final option is to place the funds with an individual separate account manager. The advantages are numerous, even with the management fees charged to the client.  First, these fees are substantially less than the markups on the bonds sold to investors by brokeragefirms.  How does an investor recoup the 2.5% to 4% increase in costs?  When managers purchase bonds, they shop the market for the best price.  There is no markup or no brokerage commission, so the client is already ahead. 

Second, the manager makes money by charging a fee for assets under management.  If the manager can increase the value of the portfolio then the income will increase.  He is working for the benefit of the client not his own pocket. 

Third, the manager can be much more tax efficient.  By communication with the client the manager can take advantage of losses or gains in the portfolio according to the individual clients needs.  This can be a huge advantage to the total after tax return of the portfolio.

We have placed clients with separate account municipal bond manager and have seen the advantage of using this method.  We urge any high net worth municipal investor to take advantage of the opportunities offered by these managers. 

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