Transaction costs for municipal securities, particularly for individual investor-sized trades, have been on the rise since early 2022, a Municipal Securities Rulemaking Board research report found.
That's a reversal of the trend that saw transaction costs declining between early 2009 and late 2021, save for the brief spike in transaction costs in 2013 during the "Taper Tantrum" when the Board of Governors of the Federal Reserve announced tapering of its quantitative easing policy, as well as in 2020 due to the general financial market turmoil sparked by COVID-19.
"This increase in transaction costs is likely due to the steep decline in bond prices triggered by rising interest rates and market volatility starting in 2022, as those factors are often associated with higher effective spread," said Simon Wu, chief economist at the MSRB and author of the report. "Tax implications associated with buying discount bonds tend to make them less liquid, which in turn impacts the costs of trading these securities. Moreover, since dealers may be inclined to charge relatively fixed markups for customer trades, when bond prices decline, transaction costs as a percentage of the purchase price generally increase."
The report also shows that spreads for institutional-sized trades, or those trades exceeding $1,000,000 par value or greater, remained relatively steady as compared to individual investor-sized trades, therefore, market liquidity may not be the main cause for the rise in transaction costs.
Wu said that it's not exactly clear why these spreads have been going in different directions but historically, institutional trades experience much less fluctuation, partly due to the fact that institutional traders monitor the market more closely.
"The other side is just the sheer volume of trades," said John Bagley, chief market structure officer at the MSRB. "If you remember, 2022 was a record year for trade count and when you see large trade counts, that usually means increased interest from individual investors," he added. "Part of the reason is just the sheer volume of buying and selling that was going on with individual investors likely had an impact on spreads on smaller size trades."
This trend also points to the fact that individual investors are becoming more and more important directly or indirectly through separately managed accounts, as banks have decreased their overall holding in municipal bonds, and mutual funds haven't seen significant inflows this year. Plus, when rates are higher, MSRB research often shows increased participation from individual investors.
The report also shows trades for premium bonds, or bonds priced higher than 100, have dropped, as the period from 2019 to March 2023 showed that 80.8% of 2022 trades and 76.3% of 2023 trades were for premium bonds, down from the usual range of 93.2% to 97.1%.
"Investors may prefer trading premium bonds over discount bonds because of the IRS's Market Discount Rule, which has a greater impact the further away the discounted bond is from par value," the report said. "Therefore, discount bonds are likely less liquid than premium bonds."
