Buy Side

GAO Report That Retail Pays More Isn't New News

A government report that describes how institutional investors pay less than individual investors when buying or selling municipal bonds isn’t news to market participants.

The Government Accountability Office report on muni bond transactions released in January said that retail investors paid an average 2.5% markup when buying $5,000 worth of municipal securities in the secondary market.

By comparison, investors paid an average of 0.4% markup when buying $2 million worth of securities.

This is significant because the report found that individual investors typically trade municipal securities in amounts of $100,000 or less, while institutional investors typically trade in amounts of $1 million or more.

And individual investors make up a significant percentage of the market. They own roughly 75% of the estimated $3.7 trillion in outstanding muni bonds, whether through direct purchases or through funds.

Those in the industry say higher markups for retail boil down to the fact that there is a market for each investor group, and they behave differently.

Retail investors do smaller trades that require more time, effort and risk to execute. And retail investors require of their broker-dealers more assistance, explanation and services along the way than do institutional customers.

“It’s not surprising,” said Steven Schrager, director of research at SMC Fixed Income Management, a boutique fixed income management firm.

“If you look at a [bond issue], one that’s active, you’ll see that the interdealer trades are much closer to par, or whatever the price is, as opposed to a retail trade. I’m not saying the retail client is getting ripped off, but you have smaller retail trades, the dealer is taking his markup to some extent, and that’s reflected in the price and the data.”

Various factors affect the markup, including the size of the trade, maturity, credit rating, and liquidity of the credit. In the primary market for new muni bond issues, broker-dealers share what the underwriters charge issuers for selling the securities.

The secondary market for municipals functions as an over-the-counter market where the difference between a bid price to buy and offered price to sell is the markup.

Critics say the muni market lacks transparency, often suffers from inadequate disclosure of financial information and is generally a treacherous place for the small investor.

Industry reaction to the GAO report may differ from the tone of news articles published shortly after its release back in mid-January.

Many carried headlines that implied that retail investors were getting gouged in their trades.

And to one retail trader in New York who did not want to be identified, a 2.5% average markup does seem excessive. His firm, which mostly prices the bonds it offers to retail and institutional customers the same, has markup restrictions based on maturity and size that never exceed 2%.

“Obviously, markets fluctuate,” the trader said. “So you can’t look at something that was bought three months ago and say, 'Oh, look. They’re marking it up more than 2.5%,’ if they’re just holding onto it for a while.”

But the 2.5% markup makes sense when the costs of a retail trade are considered, according to Michael Decker, managing director and co-head of the municipal securities division at the Securities Industry and Financial Markets Association, an industry trade group.

If a dealer owns $2 million of bonds and is selling that to 100 retail customers in different transactions instead of a single transaction with an institutional investor, the costs associated with paying the sales staff and the infrastructure associated with supporting 20 trades instead of just one affect the cost that the customer pays, he said.

In addition, the time that individual sales people take on trades for retail clients tends to be greater than the time institutional sales people take with their customers. That’s because there’s a higher duty of care that dealers have to their retail customers, Decker said.

For example, dealers to retail customers must explain the characteristics and relative risks of the bonds, answer questions, and comply with regulatory requirements that control broker-dealer transactions with individual investors.

“There’s more explanation involved, more time on the phone, associated with making sure the investor is comfortable with the trade that the dealer is suggesting,” Decker said. “Those factors come into play.”

Institutional customers also have a propensity for getting better pricing because they work with many more dealers. A typical institutional client sometimes does business with more than 100 dealers. Thus, they can sometimes play different dealers against one another to negotiate the best possible price on the trade.

“Typically, a retail customer has all or most of their portfolio with one dealer, or maybe up to three dealers,” Decker said. “They clear through the same dealer with whom they trade, and so they’re really limited, in terms of their ability to shop a trade around, which may affect the price they get.”

Ultimately, though, the prices for trades in the retail and institutional markets should be looked at separately, said Matt Fabian, managing director at Municipal Market Advisors. This makes any kind of study on bond prices for the entire municipal marketplace difficult to apply to the real world.

It’s very difficult to compare those two markets; they’re separate markets, according to Fabian.

“You have two different systems for buying bonds,” he said. “They’re built differently, they’re staffed differently — you have a whole different set of services, different expectations of the client. It’s hard to say that one is more expensive than the other.”

The GAO report, entitled “Municipal Securities: Overview of Market Structure, Pricing, and Regulation,” was mandated by the Dodd-Frank Act.

It was sent to Sen. Tim Johnson, D-S.D., chairman of the Senate Banking Committee, and Rep. Spencer Bachus, R-Ala., chairman of the House Committee on Financial Services, along with the ranking members of both panels: Sen. Richard Shelby, R-Ala., and Rep. Barney Frank, D-Mass.

The Senate Banking Committee has asked the Securities and Exchange Commission to follow up on the report, said Sean Oblack, spokesperson for Sen. Johnson’s Banking Committee. “The GAO’s report offered reasonable recommendations and Chairman Johnson looks forward to the SEC following up on them and conducting inspections accordingly,” he said.


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