Municipal Bonds Part II

| October 1, 2012 | 0 Comments

Whatever happens in Washington on the tax policy front will have a significant impact on the holders of municipal bonds (“muni bonds” or just “munis”). As I discussed in July, the benefits of owning muni bonds depends on your tax rate. The higher your tax rate, the better off you are with muni bonds lower tax-free income. Investors in lower marginal tax brackets are often better off buying taxable bonds and paying the tax on the income, because you may have more after-tax income than you would buying the tax-free municipal bonds.

So let’s assume you’ve decided that municipal bonds should be a part of your portfolio. What is the best way to acquire them? Like every other security, muni bonds can be purchased either through brokerage accounts, mutual funds, and a variety of other methods. I’ll walk through some of them in today’s column.

Brokerage Accounts.This is the traditional way to buy just about any security. The advantage of a brokerage account is that you can see the bonds you own, and all of the gory details of each one. You know when the coupon payments will be made, and you can see the price of each bond each day.

That said, there are a couple of challenges with traditional brokerage accounts. I’ve seen a lot of ads on late night TV from municipal bond “specialists.” Almost invariably, the bonds they are offering are bonds that they’ve helped the municipality to create. This is a potential problem because their job is to sell the bonds as fast as they can, for as much money as they can. Their job is NOT to get you the best bond for your situation.

The other problem is the cost. You generally have no idea how much you’ve paid to own a municipal bond because of the mark-up applied by the brokerage firm. They are sold based on yields and price. For example, I recently looked up a bond that was sold to an end client at a price of $131.369. What wasn’t obvious was that the broker paid $128.994 for that exact same bond a moment earlier. That’s a 1.8 percent commission on a single bond trade. It’s almost impossible to see what commissions or mark-ups you are paying, even for bonds traded through discount brokers like Schwab or TD Ameritrade.

Separately Managed Accounts (SMAs).The SMA is a bit of a wrinkle on a brokerage account. Instead of paying transaction costs per trade, you pay annual fees that cover trading, servicing and management of the account. In addition, you pay a professional manager like PIMCO or Nuveen to decide which bonds to buy.

In theory, this will give you the individual bond ownership of a brokerage account and better bond selection because the manager isn’t just buying whatever bonds that brokerage firm might have underwritten last week. In practice, it’s still very difficult to fully understand the costs, and few investors ever really take advantage of owning the bonds directly, like being able to harvest tax losses. Despite their advantages, these accounts tend to underperform mutual funds run by the same managers, once you include all of the fees involved.

Because the fees are lower for large accounts, these types of accounts tend to make more sense once you’re talking about portfolios of a few million dollars or more.

Mutual Funds. Despite their plebian reputation, mutual funds generally have the lowest costs and the best managers, giving them a significant advantage in the long run. I say generally because there can be a vast difference between comparable funds. For example, a Vanguard intermediate-term California municipal bond fund costs around 0.20 percent per year, compared to a similar Oppenheimer fund with a 0.81 percent expense ratio AND a 2.25 percent front-end commission. Furthermore, the income is more stable and the funds can be bought or sold with relatively low cost, compared to the high costs of buying or selling individual bonds.

This column is prepared by Rick Brooks, CFA, CFP®. Rick is Vice President for Investment Management with Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management. Rick can be reached at (858) 755-5166, or by email at Rick and his family live in Mission Hills.



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