Introduction
The municipal bond market has long been a highly appealing investment vehicle for ultra-high-net-worth (UHNW) investors, offering a unique combination of stability, tax efficiency, and reliable income generation. As a tax-exempt asset class with a historically low default rate, municipal bonds provide a dependable and secure way to preserve and grow wealth while mitigating tax liabilities—an essential concern for UHNW investors seeking to optimize after-tax returns.
While municipal bonds are inherently advantageous, their potential can be further enhanced by addressing hidden costs—specifically mark-ups on bond trades—that can erode returns over time. Many investors are unaware of these mark-ups, which are often obscured by a lack of transparency in the trading process. These avoidable costs can detract from the overall benefit of a municipal bond portfolio, especially when compounded across multiple trades over time.
This white paper explores how adopting an institutional approach, including in-house trading capabilities, and leveraging direct market access, can mitigate these hidden costs. By employing these strategies within separately managed accounts (SMAs) for municipal bonds, private wealth managers can deliver additional value to UHNW investors. Through enhanced transparency, cost-efficiency, and strong execution, UHNW clients can achieve optimal long-term outcomes, fully realizing the tax-exempt benefits of the municipal bond market.
Hidden Costs in Municipal Bond Trading
Investors in municipal bonds often operate under the misconception that their only costs are limited to a commission or service fee. However, brokers typically add mark-ups to the purchase price of bonds, which can significantly impact returns over time. For example, a broker may acquire a bond at $104 and resell it to a client at $105—an approximate one percent increase that may seem minor, but when compounded across multiple transactions, can significantly reduce portfolio value.
Despite the Municipal Securities Rulemaking Board’s (MSRB’s) 2018 amendments to Rules G-15 and G-30,1 which require brokers to disclose markups, many UHNW investors remain unaware of these hidden costs when bonds are sold prior to maturity. The opacity of the trading process, especially for retail and individual investors, impedes their ability to optimize long-term performance.2
The Institutional Advantage of In-House Trading
A notable advantage of institutional investors is their ability to execute trades without the unnecessary mark-ups that retail investors often face. Private wealth management firms with in-house trading desks bring this institutional benefit to SMAs by bypassing many of the costs associated with broker-driven models. These firms can directly access the municipal bond market through a wide network of broker-dealers, ranging from large institutions like JPMorgan Chase and Bank of America to regional firms such as Stifel Nicolaus & Co Inc.
This direct access enables a firm to purchase bonds at wholesale prices and pass these savings to clients. For example, instead of marking up a bond from $104 to $105, as brokers typically do, an in-house trader can allocate the bond into their client’s account at the original price of $104, eliminating the additional cost. Over time, this small difference can have a significant impact on portfolio performance, especially for UHNW investors managing large accounts where even fractional percentage differences translate into substantial sums.
Real-World Example: Enhancing Returns with Best Execution
To understand the tangible impact of transparency and efficient trading, consider the below example from September 3, 2024, involving a California General Obligation bond. A broker purchased the bond at $116.433 and sold it to a client at $117.933, creating an approximate 1.3% markup between the purchase and sale prices and reducing the client’s yield by 19 basis points.
(Source: Bloomberg)
While this spread may seem minor, it illustrates how mark-ups, when compounded over time, can significantly erode returns. In contrast, a firm with in-house trading could have executed the trade at a price closer to $115.810, passing the savings directly to the client and preserving the original 2.780% yield.
The municipal bond market’s decentralized nature further underscores the importance of best execution. Firms that operate with in-house trading desks can leverage their broad relationships with the broker-dealer community to identify highly competitive prices, ensuring clients benefit from optimal execution. This approach helps minimize the frictional costs that would otherwise erode returns in the long term.
The Compounding Impact of Transparency
The power of cost efficiency becomes evident over time. Consider two portfolios, each starting with $50 million in municipal bonds:
- Portfolio A earns an annual tax-exempt yield of 5.0%.
- Portfolio B earns a slightly lower annual yield of 4.7%.
Over ten years, Portfolio A grows to approximately $81.4 million, while Portfolio B grows to only $79.2 million—a difference of $2.2 million. This seemingly small gap reflects the cumulative impact of markups, missed opportunities, and inefficient trading. For UHNW investors, that extra $2.2 million represents capital that could be reinvested, deployed toward philanthropic initiatives, or allocated to other high-yield opportunities.
Conclusion
Adopting an institutional approach in the management of municipal bond SMAs can significantly enhance returns for UHNW investors. By eliminating hidden costs associated with mark-ups and leveraging in-house trading capabilities, bespoke private wealth management firms can offer clients a competitive advantage. Over time, even small improvements in pricing and execution can result in substantial gains, particularly for those managing large, tax-exempt portfolios.
As regulations evolve and investors become more aware of the impact of hidden costs, transparency will increasingly become a differentiator among private wealth management firms. Removing the opaqueness from municipal bond trading not only aligns with best practices in fiduciary management but also maximizes value for investors seeking to preserve and grow their wealth.