Municipal bonds are considered the foundation for conservative investors looking for steady income. These bonds are issued by local and state governments and pay investors income that may be substantially exempt from Federal and possibly State income tax.
During the significant stock market plunge in 2008, municipals helped protect investors from these large market losses. Municipals do carry an interest rate risk where losses will occur in your bonds when interest rates move up.
There are other risks in municipals, some of which can be reduced. There is the risk of default although they are few in number for higher rated bonds. There was a famous default in the 1980s on bonds issued by the Washington Public Power Supply System. Their default was brought on by a heavy emphasis on nuclear power in the 1970s. These bonds, part of one of the largest defaults in US history are nicknamed “WHOOPS” bonds.
Credit quality is another risk and this risk can be increased if the issuer of the bond does not provide accurate financial disclosures. In 2013, the Securities and Exchange Commission charged Harrisburg, Pennsylvania with securities fraud for misleading statements. Similar problems have occurred in Birmingham, and of course, Detroit. Moody’s Investor Services has published a history of municipal defaults and it is a good reference source.
The “mark-up” is a risk you can lessen. This mark-up is the result of a broker dealer buying bonds at a low price, then reselling the bonds at a higher price. Brokerage firms are legally allowed to charge undisclosed mark-ups up to nearly 5% so that’s a quick way to lose your first year’s return.
Although I have not sold individual municipal bonds over the years, it’s not hard to get the picture when a firm specializing in tax-exempt municipals calls with a recommendation for you to buy a bond from a certain entity. They are holding a significant volume of that issue bought wholesale and being sold with a retail mark-up.
How much mark-up are you really paying? Last month, the Wall Street Journal reported that Edward Jones will pay $20 million to the Securities and Exchange Commission to “settle charges that the firm improperly sold new bonds to customers at prices higher than negotiated with the bonds’ issuers.” A fine of that magnitude isn’t exactly petty cash, and I am willing to bet the proverbial double cheeseburger that there are other brokerage firms doing the same thing.
There are some protective steps you can take to make sure you are getting a fair price:
– Ask your bond broker what amount of sales credits is payable on your purchase. Also, ask for a
signed disclosure of the mark-ups.
– It’s important to know if the bond has been recommended on its merit or if the brokerage owns a
large quantity of the issue.
– Obtain the CUSIP number and confirm the price range where the bond should be trading.
The Electronic Municipal Market Access Website is a helpful tool. (http://emma.msrb.org/)
Given my traditional “spread the risk” insurance temperament, I lean more towards either tax-free municipal bond mutual funds or exchange traded funds. The failure of a single bond you are holding will not be felt nearly as hard if the same bond is in a mutual fund.
If you have individual municipal bond holdings, it might be a good time for a second opinion.
Sources: Wall Street Journal August 13, 2015
Investment News August 25, 2010
Investment News May 13, 2013
Wikipedia: Washington Public Power Supply System
Mike Lassiter is a Chartered Life Underwriter and Chartered Financial Consultant. He is a Licensed Insurance Counselor and a Registered Investment Advisor. He can be reached locally at 770-786-2781.
