The Dark Side Of The Muni Municipal bonds seem safe, but buying or selling them is fraught with peril. Here's how to protect yourself
By Jason Zweig

(MONEY Magazine) – If your Aunt Gertrude won the lottery and didn't know where to invest her windfall, chances are you would tell her to put it in municipal bonds or in a muni bond mutual fund. After all, most investors think of munis and the funds that hold them as the ultimate in safety: ultraconservative, buy-and-hold-forever investments that give you a state and federal tax break to boot.

But at long last, government regulators are digging into how the muni markets work--and it's nothing like you probably imagined. Meanwhile, the Internal Revenue Service is getting more aggressive in declaring some municipal bonds to be retroactively taxable--so some investors could suddenly owe income tax on past interest they believed was tax-free.

Now I don't want to scare you off munis (I'm the happy owner of a tax-free bond fund). For the most part they are safe investments. But you need to know about these new developments. In fact, armed with this information, you can invest in tax-free bonds with more security, confidence and efficiency than ever before.


If you think of the stock market as a Wal-Mart, where almost everything is available for purchase almost all the time and every customer pays the same price, then the municipal bond market is a rummage sale in the attic of the Addams Family mansion. In this cramped, cavernous space, scary surprises lurk in the dark, and almost nothing is normal--especially the prices.

A report issued by the Securities and Exchange Commission in July (see underscores just how creepy and kooky--and how downright spooky for individual investors--the muni market really is.

IT'S ENORMOUS. There are more than 1.1 million different municipal bonds outstanding from over 50,000 issuers. (That's about 80 times the number of stocks available in the U.S. market.)

BUT IT'S ILLIQUID. In a typical year, fewer than 1% of those 1.1 million issues make up half the trading volume in the entire municipal market--and roughly 70% of all munis will never trade even once.

A SMALL CLUB RUNS IT. Of the 1,600 bond dealers that trade munis, five account for more than half the trading volume.

AND THERE'S NO ESTABLISHED TRADING PRICE. You won't pay a commission to buy or sell a municipal bond, but the invisible difference between your broker's cost and the price he gives you--the "spread"--can be huge. Retail investors can incur trading costs 20 times higher than big investors such as insurance companies pay. (See page 78.)

So a few big boys who do business with one another every day run a market that has no fee structure and for the most part hardly trades at all. Care to hazard a guess as to whether you're going to get the best possible price when you enter that market to buy or sell?


At almost the same time that the SEC released its report, the National Association of Securities Dealers (which polices brokers) cracked down on eight major firms that the NASD asserts did not meet their obligation to "buy and sell [municipal] bonds at fair prices." The firms neither admitted to nor denied the charges, paying $610,000 in fines and restitution to settle with the NASD. That's chump change for them, but the damage done to individual clients was huge. A customer selling through Merrill Lynch, the NASD claims, got $2,890.50 for a bond that another dealer traded later that day for $6,229--meaning that Merrill sold the bond for its customer at less than half of fair value. At Charles Schwab, says the NASD, one client received only 70¢ on the dollar for a bundle of bonds with a fair value of 97¢--a difference of $13,500 on $50,000 in principal.

In fact, the NASD found that the brokers did not bother to find out what the bonds were really worth before they bought them from their clients. Of the firms named in the NASD action, Morgan Stanley and Wachovia would not comment, but Edward Jones, First Trust, Merrill, Prudential, Schwab and UBS all say they've taken measures to ensure better pricing.


There's one other new wrinkle you should know about. When the IRS finds that a municipal issuer has violated the rules on qualifying for tax-exempt status, it usually negotiates a settlement that keeps the bonds from being declared taxable. However, a small but growing number of issuers are refusing to settle, says W. Mark Scott, director of the IRS' tax-exempt bond division. In these cases, the agency can deem the bonds taxable and seek to collect from bondholders. If, for instance, you've owned a $10,000 "tax-exempt" bond paying 5% interest since 2000 and you're in the 33% tax bracket, you would owe about $495 if the bond became taxable.

Before you blow a gasket, let's put this in perspective: Out of 1.1 million issues in the muni market, Scott says, the IRS is considering this kind of action in only "a dozen to several dozen cases."

But there is an interesting twist here that could affect mutual fund investors. When the IRS declares a muni retroactively taxable, it can also deem a fund to be a "beneficial holder" of the bonds (even though funds are required to pass all interest on to their shareholders). The mutual fund is likely to own far more of a bond issue than you or I would directly, so the IRS can collect a big chunk of taxes from a single source. Most funds would not dare tell you that you're liable for back taxes on a "tax-free" bond they bought for your fund. In fact, says Scott, one fund company has already paid the IRS back taxes on a formerly "tax-free" bond rather than pass the bill on to the fund's shareholders. Still, there's a chance that some smaller fund outfits could ask shareholders to pay up.


Luckily there are plenty of steps a muni investor can take to emerge as a victor instead of a victim.

-- If you invest in tax-free bonds through a tax-free mutual fund, insist on annual expenses well under 0.75% (to keep your holding costs down) and a portfolio turnover rate of less than 25% (to keep the fund's trading costs down).

-- High-yield tax-free muni funds are the type most likely to hold a bond that gets declared retroactively taxable; to make sure a single bond doesn't stick your fund, or you, with a big tax bill, avoid high-yield funds with more than 15% of assets in their top 10 holdings.

-- If you prefer individual muni bonds, Jim Murphy, manager of the T. Rowe Price Tax-Free High-Yield fund, suggests buying directly from an underwriter in the "primary market," when a bond is new and trading costs are lower.

-- Martha Haines and Vance Anthony of the SEC, who led the team that wrote its report on trading costs, suggest sticking to only the biggest and most liquid bonds in the market. I'd add that you should hold until maturity, so you pass through the brokerage tollgate only once. Put up at least $100,000, and the spread on such bonds could eat up well under a penny per dollar of your purchase. (If you're investing lesser amounts, stick with mutual funds.)

-- And remember: No matter how friendly your broker is, he's not your friend. He's your broker. Never feel guilty about pushing him to do extra work. "Make 'em sharpen their pencil," advises Kenneth Woods, CEO of Asset Preservation Advisors, an Atlanta-based firm that manages $490 million, mostly in munis, for wealthy clients.

When you call to buy or sell a muni, suggests Woods, ask your broker to tell you the most recent "MSRB" trading prices from his Bloomberg machine. (By January, the Municipal Securities Rulemaking Board, which keeps a registry of all muni trades, should be reporting trades 15 minutes after they occur; you can already see yesterday's trades at Then have him contact his fixed-income trading desk for the latest valuations from Muller and J.J. Kenny (two pricing services that track munis). If there's a significant gap between these quotes and the one he started you off at, ask him why. If your broker won't or can't cross-check his original price, then Woods suggests telling him you'll go somewhere else. (Anyway, calling a couple of other firms for their best quotes is always a good idea.)

Finally, tell your broker that after he executes the trade, you'd like him to mail you a printout of all the MSRB transactions in your bond that occurred on the day of your order. If the thought of having you compare the price he got you with what other investors got doesn't put the fear of God in your broker, nothing will.

E-mail Jason Zweig, editor of Benjamin Graham's The Intelligent Investor, at