MuniBuyers.com

Why Individuals Should NEVER Buy Individual Municipal Bonds

Individuals should never buy municipal bonds or any bonds in any other form
than a bond fund.

While this is a rather broad statement, changes in the municipal,
corporate, and government bond markets in the last 5 years have clearly put
the individual bond buyer at a huge disadvantage, and frankly, a target for
unscrupulious bond dealers and the regulatory agency, FINRA.

To explain this, perhaps I should start with how the bond markets work. To
put it as simply as possible, most bonds do not trade on an exchange, so
their pricing is up to interpretation by the individual bond dealer who is
contacted to sell the bond. In your case, lets say you want to sell a bond
you bought from your Merrill Lynch broker. Most likely, you will contact
your broker at Merrill Lynch and tell him you want to sell and he will, in
turn, ask his trading desk for a bid. Since there are essentially NO
exchange for bonds, the Merrill Lynch bond desk will decide that either they
want to A: bid the bond (put a price on it) or B: put it to the street for a
bid (send the bond to a list that many brokers see if of them will bid it).

Up to this point, the process you see has been in place for decades.

In the past, when some trader wanted to bid on a bond, they had to look at
the individual security, it’s ratings, and where similar securities of similar
quality were trading and make their bid based on the bonds worth. A system
that has been in use and has allowed this country to grow to its greatness
over the last 100 years.

Unfortunately, as always is the case with money, there are some who think
YOUR money is their money. Some traders at different firms knew that the
average bond buyer/seller is ignorant of the real market, and they took
advantage of the client. An example would be if a bond’s true worth is $100
(par), they would tell the client the bond is worth $93. How would the
client know otherwise. If the client sold the bond at 93, the firm would
then resell the bond at its true value 100, generating a 7% profit. Over the
years, some firms took advantage of unsophisticated clients and took from
them for up to 25% of the value of their bond all while the client never
knew this.

Over the years, firms took advantage of so many clients that eventually the
regulatory agencies (NASD, now called FINRA) set “mark up” rules. These
rules stated that the firms could only have a 5% maximum spread between what
they paid one client and then sold to another client. As will all good,
greedy firms, they either ignored this or found a way around it and
continued to “pick off” the unsuspecting!

FINRA, knew it had to do something to regulate the firms. Bad publicity was
getting out of hand. It had two choices. One was to scrutinize each
transactions to watch the amount of spread that the firms put into there
offerings. In other words, have them report the difference paid between
what they bought and sold bonds. This way, they could easily see who was
violating the rules and question those trades. With today’s computing
capabilities, this would be very easy to do.

Or, the other choice was to create a reportable database of all trades and
watch that database to see if any extreme spreads were seen. This was
actually a harder system to filter out the “crooks” because a relationship
between the buy trade and sell trade would be harder to see as it only
identified trades and not the brokers.

So, FINRA choose the second method, a reportable database. I guess the
theory was that this concept was closer to an “open” or “exchange” type of
market and would look like a good attempt to create a transparent “market”
for bonds. Unfortunately, the concept really does not work and never solved
the problem of the CLIENT getting a fair price for his security.

To sum this up, to solve the problem of unethical brokers paying clients below
market prices, FINRA choose a system that allowed the unethical broker to flourish
and in fact, aided them in widening spreads between the bid and ask prices.

So, how has this all helped the CLIENT get fairer pricing? For the most
part, it has not. However, in all fairness, a client can now go to
http://emma.msrb.org/ enter a cusip and see where their bonds have
recently been trading. However, this in NO WAY shows the client what is
FAIR PRICING. However, on http://emma.msrb.org/, bond buyers and owners
can see exactly that the spreads between the sell and buy transactions are
wider than ever. And, these off market prices ensure that clients will not
get fair pricing.

Let me give you an example of what I mean. If client A sells a bond at
$96, it now shows on the database. This has nothing to do with fair value,
but only the price at which the bond was sold. (Lets assume fair value is
$100)

Let’s say that now client B wants to sell his holdings of the same bond.
Remember, what I told you above. In the past, when a client wanted to sell
a bond, a trader who wanted to bid on the bond would look up the rating, the
description, where new issues of like securities were trading and then
determine a FAIR price. Now, with the new reporting system from FINRA, the
average trader will look at the last price paid, and pay you less. This
takes most of the risk out of the trade for the firm bidding the bond. But,
in this case it also further “SCREWS” client B.

If client A is bid $96 and client B now gets less, say $95.5, then, the
market for these bonds continues to loose additional value in the brokers
dealer’s favor. Until a real trader (one who still uses real
valuation methods/models) comes along to bid this bond, its market value
will rely solely on its last transaction. But, since there are hundreds of
thousands of individual issues in the municipal market, it may be months or
years before this bond is bid again.

Further exasperating the situation is the fact that many firms are now
putting bonds on a service called BOND DESK for the bid instead of bidding
for them outright.

By doing this, they are taking a moment in time, a brief period, and hoping
that some honest intelligent bidder of bonds is sitting at his desk watching
the “bid wanteds” and gives you a good, honest bid for that bond. How
likely is that?

Unfortunately, the honest broker may not be out there at that time or his
attention may be drawn away. And, your bond ends up being bid by an
opportunist. Opportunists sit on the computer all day long putting what are
called “throw away bids” on the bid wanted lists. They low ball bids the
list with hopes of picking off the unsuspecting client and the uncaring and
understaffed trading desk.

So, if client B’s bonds go to “the street” for a bid, and they get bid $90
and unsuspecting client B sells his bonds at that price, the new “market”
price for those traders who use this to bid bonds is now 10 points below the
fair market price.

Here is the bottom line: FINRA chooses to go with a far less intrusive
system where they would be less likely to actually catch the thieves in
action, to one that on the outside may have looked like it would be of
benefit to the client but is not. The un-intended consequences (some may
say INTENDED CONSEQUENCES) continue to take advantage of the client.
Shame on FINRA, your laziness and insiders approach to managing your broker
dealers continues to be one, big giant failure.

But fear not, you owners of bonds. There are ways to protect yourselves.

First, on your statements each month, there is a value assigned to your
bonds. This price is actually very close to the value of that security.
Your broker, if you ask him/her, will deny this. But in my 30 years of
trading bonds, a good bid price is ALWAYS within 2 points of that price.
Meaning, if the statement shows a value of $100 the bid should be now lower
than $98. Depending on the number of bonds you own, it should be higher as
the quantity you own goes up.

A 2% spread is reasonable profit for a firm.

Second, you should check http://emma.msrb.org/ to see where your bond has
been trading. Look at the “purchase from client” price. ALWAYS check your
pricing after you sell to see if your broker sold it to the street and took
a lot of commission from you.

Third, just because your bond is being held at one firm does not mean that
you cannot sell it to another firm. Go to other firms and ask for bids.
You may have to open an account with that firm to do this. But, once you
do this you will be able to sell to the highest bidder. If you do sell to a
firm other than the one holding your bonds, you will then need to transfer
it “FREE” to your other account. This can be accomplished by writing a
letter of authorization (signed by you) to the delivering firm. Be aware
that if you do this, you are required to have that bond delivered on or
before settlement date.

Lastly, to those of you who still want to buy individual bonds. Do the
same as sellers. Ask your broker before you buy a bond what the JJ Kenney
evaluation is on the bond (JJ Kenny is the CarFAx of the bond market).
If they cannot tell you what it is, don’t buy the bond from them. Check
the bond on http://emma.msrb.org/ to make sure
that it is indeed selling at the prices they are asking.

A final word of caution, if a broker tells you he sees inventory from all
over the “street” or all brokerage firms, run, do not stop until you are far
away from him/her. Most of the bonds firms show other firms are there old
over priced inventory.

ALWAYS check a bond in the above mentioned ways before you buy it. And don’t forget
to check the ratings also.

Good Luck!