The Problem: Retail Pricing Model
The retail broker/dealer for munis is primarily concerned with how to pay the salesperson to sell or market muni product and how the retail trader can maximize his/her trading profits. This is an incentive-based system for retail firms. Most retail brokers are paid on commission, only the commissions are buried in the offering price of the securities. A retail trader will determine what type of securities his/her sales force can sell. He/she will make an assessment that includes maturity, quality, coupon, and absolute yield levels. A retail trader also knows what type of incentive or mark-up is needed to offer to get his/her sales force to sell the firm's offerings. He/she then looks for bonds with desired characteristics and positions them in inventory for the sales force to sell. His/her ability to find the right merchandise with the right mark-up will determine how successful a retail trader is. Studies have shown these mark-ups can be significant and will be influenced by such factors as maturity, quality, and block size.
Transaction Costs For Retail
In 2004, there were two independent studies published which addressed the typical bid/ask spreads for retail muni investors. These studies are shown in the table below. The typical spread was between 2-2.50%. Most retail investors have an account with only one firm. This gives the broker dealer a captive situation, because the client is not able to get competitive offerings or bids from other dealers. This can lead to a conflict of interest on the part of the dealer and poor trade execution for the client.
Problems For Individual Investors
There are additional problems for the retail buyer of munis. These difficulties pertain to valuation of securities.
The typical retail buyer has difficulty within this model in the following areas:
1. Callable Securities- It is best to value callable securities with appropriate bond software, which can be expensive and require specialized expertise. Very few retail investors know how to use OAS (Option Adjusted Spread) to value callable bonds. Instead, they may tend to underestimate the value of calls and buy callable bonds that look attractive on a yield to maturity basis, but are very unlikely to be outstanding to maturity. If they get called, they may turn out to be unattractive instead. It is not difficult to make this valuation analysis, but it requires tools and knowledge that is out of reach of most retail accounts.
2. Credit Spreads- There are over 50,000 different issuers of municipal securities. In order to have a clear understanding of how they should trade relative to one another, the investor requires specialized knowledge and a system for valuing these securities. A retail investor may easily underestimate how wide a credit spread should be for a lower quality credit in comparison to higher quality securities. This would enable a dealer to make a larger mark-up at the expense of the unknowing retail investor. Most retail investors are “flying blind” and have no solid basis for price relationships based on credit spreads.
3. Coupon Spreads- Retail investors tend to have a preference toward purchasing par bonds (bonds priced near 100.) This makes these bonds overpriced in the market relative to other coupons available. Our studies have shown that premium bonds are less risky (they have lower duration), return principal faster (which allows us to take advantage of higher reinvestment rates in a rising rate environment), and avoid the market discount rule. We are generally able to buy these coupons at wider spreads than par bonds. This is especially true when buying in block sizes of 100,000 or less.
4. AMT- About 5% of the muni market consists of bonds that are subject to the Alternative Minimum Tax calculation. These bonds are issued with a public purpose, but there is a benefit to a private party. Stadium bonds, airports, and single family housing bonds can all be examples of AMT bonds. The trend is for more and more individuals to be subject to AMT status. We believe the spread vs. non-amt bonds could widen in the future as a result of this trend. Retail accounts may have difficulty knowing what an appropriate spread for AMT bonds should be. They may look at their own situation and if they are not in AMT status, they may undervalue the spread for AMT bonds and pay too much.
5. Maturity Spreads- Muni bonds are issued serially out to about 30 years. The yield curve is generally upward-sloping. This gives an investor an incentive to extend to pick up extra yield. It may be difficult for a retail investor to know how to value the amount of risk he/she is taking by extending for any given amount of yield. This could lead the retail account to extend too much for too little benefit.
The Solution
A professional bond manager has the necessary institutional bond tools to value the above-mentioned securities properly. These tools include Bloomberg software and The Bond Buyer, a specialized daily bond news publication. Institutional money managers have also built up an institutional network of dealer coverage that allows them to narrow the bid/ask spreads of individual securities significantly. This combination of low transaction costs, (like a mutual fund) and establishing a tax-basis on each individual security (like a retail investor) is a powerful solution to the Muni problem. The portfolio can then be tax-managed cost-effectively by doing tax-swaps when it is advantageous, and by building state preference portfolios.
No comments:
Post a Comment