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Welcome to the Breckinridge podcast. This is Ariana Jackson and joining me today, I have Jeremy Jenkins, CFA and vice president on our Consultant Relations Team. Jeremy and I will be discussing trading markups in the municipal bond market as a follow up to Breckinridge's blog post on the topic last month. So Jeremy thanks for joining us today.
Thank you Ariana.
So jumping in, can you explain what a markup is?
Sure. Markups occur anytime a bond is traded between investors. It's a natural part of a functioning market for dealers to collect a small portion of a trade for their part in facilitating transactions. Now, markups in the municipal bond market have received more attention over the past number of years due to concerns over excessive markups impacting primarily smaller retail investors. This can occur when a broker purchases a bond on behalf of a retail client where the price the client receives is abnormally higher than the price the broker purchased the bond at, assuming the market is relatively flat in terms of price movement. Also, the term "markdown" is used when referring to the other side of the transaction, that is when a bond is being sold by a client to a broker, it's possible that the price is meaningfully lower than the prevailing price or most recently traded price on that particular bond.
So is it fair to say that excessive markups or markdowns are like a commission for the broker?
Well, they're not a commission in the sense that commissions are transparent and understood before a transaction takes place, but it is thought of sort of an embedded commission for a broker when transacting in the municipal bond market on behalf of a client, but unlike, say, the stock market where an investor is charged a transparent fee or commission by their broker before entering into a trade, an investor buying or selling a municipal bond through that same broker is not required to receive a similar type of disclosure before or after the transaction.
And what explains this difference in how trading costs are handled or disclosed in these markets?
Yeah, the trading landscapes for stocks and municipal bonds are quite different. We've discussed this in the past in previous podcasts and white papers, but the municipal market is much more opaque whereas the stock market is much more transparent. The muni market is fragmented, with hundreds of different dealers, thousands of different issuers, and millions of different bonds. Further, the vast majority of outstanding bond issues don't trade in a given day and, in fact, many won't trade in a given year. Moreover, it's an over-the-counter market where buyers and sellers negotiate prices opposed to a quoted exchange base market. Finally, federal rules regarding markups are somewhat ambiguous in that they simply state that markups should be, and I quote, fair and reasonable. However, that provides no specifics on what that exactly means. All of this results in a market that can be difficult and costly for an individual buyer who’s not typically in the market and who is unfamiliar with yields and spreads and their corresponding value.
So Jeremy, let's try to put some numbers around this. Can you provide some examples or statistics around markups?
Sure, so let's start with a general example of a AA rated, 5% coupon bond. Let's say it was offered to a customer by a dealer at 118. Let's say it was purchased through the interdealer market at 116 that same day and from another customer at 115 the day before. So, in this example, just on the difference in price from the trade made broker-dealer to broker-dealer to the price the customer received, that bond was marked up about 2%. And add on another 1% if you consider the price the bond was purchased at from another customer the day before. This is an example of not only a pretty sizable markup, but also an example of what we call a transaction chain, this being two separate broker-dealers affecting trades with customers at each end of the chain, one dealer buying from a customer and the other selling to a customer. In this example, the broker-dealer who purchased this bond from the selling customer marked it up about 1% when selling to the other broker-dealer and then the actual broker selling to the buying customer marked it up about 2%.
That seems like a pretty significant difference.
Yeah, this example isn't that surprising if you look at some of the recent studies that have been published on the topic. For example, a couple of years ago, the SLCG, the Securities Litigation Consulting Group, put together an interesting study. Their specific analysis looked at about 30% of trades from 2005 to 2013 in traditional fixed coupon long-term municipal bonds. What they found was that investors were charged a little over $10.5 billion in markups during this time period and of that $10.5 billion, they determined about $6.5 billion was in excessive markups. Their definition of excessive was essentially if a bond was marked up twice the median markup for similar sized trades or if there was a markup more than half of 1% (0.5%) on recent trades in that same bond. Now, they also reference studies that have analyzed the average markup for retail investor versus institutional investors, where the average markup for the retail investor was 2.5% higher than the institutional investor. They also reference report from the GAO, Government Accountability Office, that attributed much higher trading costs for smaller municipal investors.
So given the examples you cited and the studies, what's the appeal for individual investors to have a broker periodically buy and sell municipal bonds for them?
Well, I think often investors look at this asset class, high-grade municipals, as a pretty plain-vanilla boring place in their overall portfolio that they don't have to worry about too much and largely, I think that's correct. Our philosophy at Breckinridge has always been that an allocation in this space should be a stable, reliable part of investor's asset allocations, but that's not to say that there's not risks in this market. Certainly, credit research and portfolio construction are important to navigate risks, but given today's topic, let's focus on trading and execution. I think some investors believe they are better off not paying a transparent management fee. Anecdotally, you will hear some investors say, you know, why would I pay a management fee, I have someone, i.e., a broker who buys these for me and doesn't charge any management fee. Well, as the example and studies previously mentioned would suggest, there is an inherent fee baked into the price of the bond which can be as high as 2 to 3% if it's marked up, and plenty of these investors have no idea what they're being charged because, as I mentioned previously, they don't have to have that information disclosed to them.
Have we seen this issue garner more attention from the media or regulators?
Sure, yeah, there has definitely been more coverage from news outlets over the past few years, Wall Street Journal, Forbes, Fortune, Barron's, etc. have covered the topic in varying amounts of detail and there has been more discussion in the past year or so about increasing disclosure from the MSRB, that's the Municipal Security Rulemaking Board. Nothing has been made official, but under the current markup proposal, there could be more transparency around the total dollar amount of the markup as well as the percentage of the principal amount.
So Jeremy, what do we think investors should do if they want to inform themselves about markups and help guard against them?
Well, the good news is that transparency is getting better in the municipal bond market and this issue has been getting growing attention from regulators and media outlets, as I mentioned, so a simple Google search can actually provide a fair amount of information. Maybe even better than that, EMMA, the MSRB's repository for municipal bond trade data, is a great resource for investors who want to look at trade data on their bonds. The MSRB's main website also is useful for finding existing and proposed markup rules. We actually include links to both of these in our blog post from last month. Additionally, we would suggest individuals consider using a municipal bond specialist, like Breckinridge, that does not markup bonds, rather, simply works on behalf of the client to buy the best bonds at the best prices. And specific to Breckinridge, we have access to over 150 dealers across the country in order to get the best execution for our clients, and at the end of the day, trading costs for institutional managers like Breckinridge and a transparent management fee taken together, may be less than the trading cost of going through a non-specialist, and I’d note that the trading benefit doesn't even factor in the benefits of credit analysis and portfolio structuring that we mentioned before a firm like Breckinridge is much more likely to bring to bear than a retail broker.
Thank you, Jeremy. We hope that you in the field have found this informative and we look forward to joining us again next time.
DISCLAIMER: The material in this transcript is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Portions of this transcript may have been edited from the original podcast recording to improve clarity of message. Nothing in this transcript should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. This document may contain material directly taken from unaffiliated third party sources, including but not limited to federal and various state & local government documents, official financial reports, academic articles, and other public materials. If third party material is included, it is believed to be accurate, and reliable. However, none of the third party information should be relied upon without independent verification. All information contained in this document is current as of the date(s) indicated, and is subject to change without notice. No assurance can be given that any forward looking statements or estimates will prove accurate or profitable.