SLCG Economic Consulting's Logo


Retail Investors and the Municipal Bond Market

This week, we will be discussing the buying and selling of municipal bonds by brokers on behalf of retail investors. But to start, let's address some basic questions about the municipal bond market.

What are municipal bonds and how are they traded?

Municipal bonds are simply bonds issued by a state and local government or authorities. Municipal bonds can be general obligation bonds, meaning they are not used to fund specific projects, or they could be issued to finance a new highway, a public works facility, a school system, etc. or to refinance existing debt. They are traded in an over-the-counter market by broker-dealers who profit from the difference between the price at which they buy and sell bonds from investors. At the end of 2012, $3.7 trillion in municipal bonds were outstanding, about 75% of which were held directly or indirectly by individual investors.1

Why do retail investors purchase municipal bonds?

Municipal bonds are generally considered very conservative investments. While municipalities have defaulted in the past, their default rate has been relatively low (only 0.15% for rated, investment-grade municipal securities according to SIFMA).2 Also, the income from municipal bonds is tax-exempt for investors who purchase municipal bonds issued in their own state.

The municipal bond market has widespread analyst coverage. As just one example, SIFMA publishes a very helpful quarterly report on the municipal bond market which includes market summary data as well as yield and total return analyses.

What is a 'markup' on a municipal bond?

Dealers sell municipal bonds to investors at higher prices than the dealer could get him or herself in the open market. This difference is referred to as a markup, and represents the profit to the dealer for making the trade on behalf of the investor. Similarly, a markdownthe difference in price the dealer receives and the amount credited to the municipal bond owner upon sale of the municipal bond.

The Municipal Securities Rulemaking Board (MSRB) has provided guidancefor the calculation of markups of municipal bond trades. The MSRB methodology suggests comparing the trading price of a customer municipal bond trade to contemporaneous inter-dealer trades. This can be accomplished using the MSRB's Electronic Municipal Market Access system ("EMMA"), to which all municipal bond dealers in the US must submit trade data, including the trade date, quantity, and price.

What are retail investors actually charged for municipal bonds?

SLCG's analysis of the municipal bond trades shows that the some purchases were executed well above the prevailing market price. By comparing the observed spread (difference between customer purchase price and the prevailing inter-dealer price) to the distribution of markups charged on similarly sized trades, they find that retail investors were charged between $1.84 billion and $6.45 billion in excessive markups in a sample of fixed coupon issued after January 1995 and maturing after January 2025. While large, SLCG's sample covers less than 30% of the transactions in municipal bond, so total markups may have exceeded $20 billion and excessive markups may have exceeded $10 billion since 2005.

How have these excessive markups been allowed to persist?

Even though data on municipal bond trades is publicly available through EMMA, there are no current prices quoted for municipal bonds on public exchanges. Therefore, investors have no pre-trade knowledge of the market price for their bond. This lack of pre-trade transparency means that investors don't always know what the markup was on their trade, or what the prevailing inter-dealer prices were when it was executed.

Where can I learn more?

For more details, please see SLCG's research paper on markups in the municipal bond marketplace. You can also find coverage of this paper in Jason Zweig's story for the Wall Street Journal.


1 SIFMA Outstanding U.S. Bond Market Debt
2 For example, the recent bankruptcy of Stockton, California and the notorious bankruptcy of Jefferson County, Alabama).