We’ve discussed with clients why we prefer investing in municipal bond mutual funds rather than individual municipal bonds or municipal bond ETFs (exchange traded funds). Municipal bonds are tax-free investments issued by state and local governments.
We think muni bond mutual funds are superior for several different reasons (we discussed a few in our previous article Investment Myths: Are Individual Bonds Better Than Bond Funds?). You may be surprised to hear that our preference for mutual funds is widely shared by other advisors and portfolio managers.
One big reason has to do with costs.
If you think that buying individual bonds from a broker must be cheaper, think again.
Individual bond trades are padded with high markups – extra money to the broker – that you don’t even see.
One investor recently profiled in Bloomberg News purchased a municipal bond through his broker. Little did he know that he paid a $1,500 “markup,” or hidden charge buried inside the purchase. Since there was no “commission” on the bond purchase, he thought he was buying the bond for free. Wrong.
He didn’t realize that retail investors (those making individual bond purchases of $100,000 or less) typically pay more for bonds than institutional investors. According to Bloomberg, dealers embed their fees in the purchase price but aren’t required to disclose them.
“A year’s worth of interest can be wiped away simply by buying or selling a bond,” complained Securities and Exchange Commissioner and investment regulator Michael Piwowar, as quoted in Bloomberg.
“Some financial advisers suggest mom-and-pop investors stay away from buying individual bonds, because even small markups can eat up the returns on low-yield securities, and those fees can be hard to identify,” added a recent expose in the Wall Street Journal.
A Standard & Poor’s study of muni bond markups found that the costs can really add up. You should “expect to pay about 1.62% in markup on your munis. If you buy a muni bond with a face value of $50,000, you’ll pay about $810. You’d pay the same if you sold the bond before it matures. In today’s low-rate environment, that’s about half a year’s interest.”
The lower costs of mutual funds is a big advantage, concludes Morningstar, which tracks and rates all types of muni bond investments. “Transaction costs are high in the bond market and the large scale of bond funds helps to reduce expenses.”