(May 2012) I recently interviewed 3 well respected municipal bond portfolio managers: Peter Hayes of Blackrock, Scott Cottier of Rochester Municipal Funds, and Robert Amodeo of Western Asset. The topic of those interviews was how they go about finding value in the municipal bond market. After speaking with each of them however, I also got to thinking about the following question:
Is it possible for an individual investor to replicate what professional bond managers do when buying individual municipal bonds?
Unfortunately I think the answer to this question is no, and here’s why.
There is an inflexibility of supply in the municipal bond market for two reasons:
One major brokerage firm estimates that less than 10% of all municipal bond issues are available for retail investors to trade electronically at any given time. While most major brokerage firms offer electronic trading, the lack of supply available to the individual investor makes constructing an individual bond portfolio a major undertaking. Imagine how difficult it would be to trade stocks, if for every 10 times that you wanted to purchase a particular stock, you could only execute a trade once. (For more on the differences between trading stocks and bonds go here.)
The ability to better deal with the lack of supply in the municipal bond market is one area where institutions have a major advantage over the individual investor. Bond Funds and other types of institutions can access a supply of bonds which an individual cannot. They have information on which institutions own various bonds, and can contact them to arrange a transaction. If they do not already know where the bond they are looking for can be found, they can announce that they are interested in buying a particular bond issue, and solicit bids. The professional mutual fund manager (or their trading desk) also has the advantage of being constantly immersed in the market. While a bond might be available for a good price today, it might not be tomorrow or the next day. A professional trading desk can watch for attractive issues which have recently come up for sale and alert the portfolio manager to the potential opportunity.
When a transaction does occur in the municipal bond market, institutions normally get a much better price than individual investors. A recent study on the difference between the prices received on trades by institutions and individuals showed a difference of over 2.0%, in favor of the institutional buyer. In today’s low yield environment this difference in execution price can account for the majority of the interest earned on a bond for an entire year.
There are a number or reasons for this large difference in price:
Bottom line: an institutional investor is going to get a better price than an individual trader*.
(*Retail Offering Periods are one exception to the above rule. When a bond first comes to market, retail investors have may have an opportunity to get bonds at the same price as institutions. However, I believe building a portfolio solely around retail offering periods is not practical solution for individual investor looking to create a diversified portfolio over a short-period of time and would require fairly extensive commitment of time. You can learn more about retail offering periods here.)
Assuming the cost of investing in a municipal bond mutual fund is around 1% per year in management fees, the individual investor comes out ahead investing in the mutual fund on a cost basis, after factoring in how much more they would have to pay for the bonds. If you are interested in learning more about municipal bond mutual funds, check out the bond funds section of LearnBonds.com.