Dana's Guide To The Big Rip-Off In Municipal Bonds

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Includes: GTFBX, MUB, SCHW
by: Dana Blankenhorn

Summary

Municipal bonds should be the next big thing, offering baby boomers guaranteed retirement income.

Default rates are low, but expenses are high because the market is so thinly-traded.

So were mortgages, once upon a time.

Both issuers and investors are being robbed of billions of dollars each year by the illiquidity of the $3.6 trillion municipal bond market.

This is not the fault of the people who cover the space. Nor is it the fault of big government, or even the big brokers.

It's a function of the market, or more precisely the lack of one.

I think Municipalbonds.com does the best job of covering this area of the market. It's owned by Mitre Media, a venture-backed collection of financial Web sites run out of Edmonton, Canada. That's a good analogy for how far from the center of the investing action munis have gotten.

While municipal bonds are one of the oldest markets around - the Crash of 1837 was caused by state bonds used to fund canals - each bond is a unique proposition. Some assure payment based on a specific revenue stream. Others are "general obligation" bonds, guaranteed only by local taxes. Bond ratings, based on the chance of default, also make a difference in yield. All this, along with the general interest rate environment, go into determining both the coupon rate of the bond at issuance and its value to you later, whether it's worth more or less than the face value.

In his 2016 budget, the President called for the creation of Qualified Public Infrastructure Bonds, or QPIBs, which would extend the tax-free status of municipal bonds to public-private partnerships, and eliminate the Alternative Minimum Tax limits that cap what rich people can earn from such bonds.

That might lead to more issuance, but it wouldn't do nearly as much to help investors as simpler standards would. If a broker could bundle municipal bonds into securities, as has been done with things like mortgages, it would make such bonds much easier to trade and deliver more transparent pricing.

There's nothing like a New York Stock Exchange mechanism for munis, although the folks at TradeDesk's BondDesk or the The Muni Center will disagree. They just don't have the volume, thus they don't have the float, to give traders the pricing you get on stocks traded electronically. These markets are only open to dealers, and while you can make a trade through an online broker like Charles Schwab (NYSE:SCHW) the spread between bid and ask is going to be enormous, as are the trading fees collected, when compared to, say, 100 shares of GM (NYSE:GM).

Despite the big headlines caused by defaults like those of Detroit and Birmingham, Alabama, municipal bonds are still about the safest things you can buy. Even with Detroit's bankruptcy last year, the overall default rate was .227%. That's zero-point-227, meaning barely one bond in 400 was subject to a default. Normally the default rate is half that, meaning that barely one in 1,000 bonds default. Try getting that kind of rate in corporates.

A thin market means wide variations in prices, and thus the interest rate yield a buyer will get. TradeDesk does a monthly "transparency report," whose latest issue shows that the further out you go on the yield curve - the longer the maturity of the bond you're buying - the bigger the spread between municipals and U.S. treasuries, which also offer tax-free income.

The trouble with the extra tax-free benefit is that it's very specific. If you live in a city that taxes personal income, in a state that taxes personal income, like New York City, your municipal bond income gets three tax breaks. If you live in Texas, with no personal income tax, you only get the federal break.

The illiquidity of bonds makes funds holding them seem like a good deal. Vanguard, for instance, says it will soon release a municipal bond ETF, one that's traded like a stock. It would track an S&P index currently yielding 1.7%, with an expense ratio of 0.17%. The average municipal bond fund, by contrast, has an expense ratio of 0.49%, and the cheapest of those funds, the iShares National AMT Free Muni Bond ETF (NYSEARCA:MUB), has an expense ratio of 0.25%.

Given the tiny interest rates we're talking about with municipal bonds that is no small difference.

All of which makes state-based funds, like those of T. Rowe Price, start to make sense, despite an even-higher expense ratio. Their Georgia (MUTF:GTFBX) fund, for instance, carries an expense ratio of .54%. That means for every $100 you get in profit from the fund, 54 cents is going to the fund operator. Not bad, but when you are talking about a fund whose yield averages 4%, that means more than $1 in every $8 of profit is going into the fund manager's pocket, not yours.

If you have an estate at retirement with $1 million in it, you can toss that into municipals and get something like $40,000 of income from it tax-free. A lot of baby boomers are going to be in that position over the next five years. Full disclosure, I'm going to be in that position.

A more transparent market when we get to that point would be a big help.

Disclosure: The author is long SCHW.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.