Joseph G. Mowrer III, The Daily Record Newswire
The municipal bond market is complex. It is vastly different than any other market in terms of its size and fragmentation. There are over one million individual bonds across 55,000 different issuers that comprise this $3.7 trillion market (Source: Municipal Securities Rulemaking Board). While some of these bonds share some common characteristics, they are largely different in terms of their source and stability of revenue (risk).
Municipal bond investors represent perhaps the most risk-averse group of investors there are. They all generally want the same thing - dependable tax-free income with minimal credit/default risk. Because of the massive size and the number of issuers in this market, it is difficult (or impossible) for the average investor to achieve this objective by doing their own research. Yet even given this complex market, it is interesting to note that nearly half of the $3.7 trillion of municipal bonds outstanding are actually held directly by households.
While the overall municipal bond market as a whole has historically been extremely safe from a credit perspective, there are always going to be individual instances of municipal bond defaults. These isolated defaults are rare, but often come without warning to the average individual bondholder. Detroit and Puerto Rico have been making regular news over the past year or so for their fiscal problems, and have certainly been giving households who own any individual municipal bonds a scare.
Are households really expected to peruse the offering documents for 55,000 different issuers? Obviously not. Choosing the right bond for the right price requires careful credit research to determine which bonds offer the best value.
BlackRock and Nuveen are two of the largest municipal bond fund managers and each have hundreds of highly skilled people devoted solely to credit research. They can identify the risks of particular issue years or perhaps longer before the story actually hits the news.
Often, it is this headline news that creates a panic in the marketplace and allows these expert bond fund managers opportunities to buy high quality securities at discounted prices. Further, these fund managers only have 2 to 3 percent of their fund's assets in any one particular issue, and are highly diversified geographically and across industry groups.
Individual bond holders may argue that they are being fairly compensated for taking on single-issuer risk since they do not have to pay management fees. While this may be true, there is a catch. Large institutional investors (i.e. mutual funds) get a huge pricing advantage versus individual bond buyers.
According to a research piece from Nuveen Investments, the average trading spread (markup) for a municipal bond of trade size greater than $1 million is only .36 percent, whereas this markup is estimated to be 1.58 percent for smaller retail size trades. The difference of 1.22 percent in favorable pricing goes directly into the pockets of shareholders of the fund, and more than covers the management fees for any reputable fund manager. Investors are essentially getting the benefits of a diversified, professionally managed bond fund for less than the cost of an individual bond.
In today's low rate environment, it is very difficult or impossible to find extra yield without taking on unwanted risk. But it is possible to do so by hiring a reputable municipal bond fund manager to maximize returns while protecting principal. As it turns out, maybe there is such a thing as a free lunch.
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Joseph G. Mowrer III is a senior tax-sensitive fixed income analyst for Karpus Investment Management. He can be reached at (585) 586-4680.
Published: Fri, Aug 15, 2014
