A new study says the funds are cheaper if you actively trade.

If you're actively trading your clients' municipal bond portfolios, some experts say you may be better off investing in a bond fund that sports a low expense ratio. In fact, individual investors actively trading bonds may pay double the transaction costs of institutional bond traders, according to a recent study co-authored by Securities and Exchange Commission Economist Lawrence E. Harris.

Effective spreads on individual municipal bonds average about 2% of price for retail-size trades of $20,000 and 1% of price for institutional-size trades of $200,000, says the study Harris conducted with Michael S. Piwowar, a visiting academic scholar in the SEC Office of Economic Analysis. The two, who have said in published reports that the research did not necessarily reflect the views of the SEC, examined 167,000 municipal bonds over a one-year period.

The municipal bond liquidity study, released in February, attributed what seemed to be significant price gouging for smaller, retail-size trades to the lack of transparency in the market. The SEC already had been complaining about this lack of transparency. "Large institutional traders generally have a good sense of the values of municipal bonds, whereas small traders do not," the study says. "Our results are not simply due to fixed per-trade costs ... Rather, they appear to be a fundamental consequence of the market structure."

The study reports that municipal bond trades are substantially more expensive than similarly sized equity trades. Unlike stock trades, municipal bond transaction costs decrease with trade size and do not depend significantly on trade frequency. "We expect that ongoing regulatory initiatives to increase transparency in the municipal bond market will lead to liquidity improvements," it says.

Christopher Taylor, executive director of the Municipal Securities Rulemaking Board (MSRB) in Alexandria, Va., the agency Congress created in 1975 to regulate dealer behavior, says a major problem lies in the nature of the market. While the stock market has fewer than 50,000 different securities, the municipal bond market has 1.5 million tradable securities. "It's impossible to have a quoted market on 1.5 million different securities," he says.

You can view information on municipal bond trades at www.investinginbonds.com, a Web site run by The Bond Market Association in New York, which uses data from the MSRB. Although you can search a municipal bond issue online, he says, only 1% of municipal bond outstanding trade. A chief reason: Municipal bond investors, he explains, frequently are buy-and-hold investors, seeking a stream of income. They aren't traders.

"If an investment advisor is trying to sell a position for a client, you might find it has not traded for two years," Taylor says. As a result, he adds, an advisor has no choice but to examine what it was trading at two years ago in relation to a benchmark, such as the Treasury curve. Of course, you have to take into consideration other factors, such as an assumption in the change in the credit quality of an issue.

Only then can you determine about where the price should be. "This ain't like the equity market where everything trades every day," Taylor says. "It's as if you're looking to get a price of IBM, but IBM doesn't trade."

Next-day prices on municipal bond trades are posted on the Web site as well as pricing on an issue's historical trades, he notes. The MSRB plans to implement real-time reporting in January, Taylor says, which should track trades within 15 minutes of execution. "We expect to begin certification testing with members-to make sure they've got their systems in place and they're ready to roll-starting sometime in July," he says. "We're forcing all dealers to test with us as a way of insuring the system comes up."

But even real-time reporting, he says, won't solve the fundamental transparency problems with the municipal bond market. Of course, if you buy a municipal bond and hold it to maturity, you have no ongoing expenses. That compares with an average 1.09% expense ratio for municipal bond mutual funds, according to Morningstar. However, if you are adjusting a client's bond portfolio to change the duration or for tax swaps, you could rack up large expenses by buying bonds individually on the secondary market.

Some experts believe these costs could overshadow the cost of no-load bond funds, which sport expense ratios of as little as 20 to 50 basis points. Even before the results of the municipal bond liquidity study William Brennan, a fee-only CFP licensee and CPA with Capital Management Group, Washington, D.C., had shunned individual bonds traded in the secondary market. He only invests in original-issue bonds and low-cost funds.

"You don't have good control over the mark-up, costs and expenses involved," Brennan says. "Bonds [require] a special expertise beyond what you may even need to be a stock picker. You know what the price is for a stock. For bonds, you really don't know. If somebody is getting an extra 20, 30 or 40 basis points, that can be an awful lot of money. I've got to think we're better off using managers."

Brennan figures that with a bond fund, you not only start out with lower expenses, but a good fund manager can pick up another 25 basis points in total return. He admits that he has shifted gears recently due to the fact that rising rates trigger a major problem with bond funds.

When interest rates rise, the value of a bond fund falls. "You're never guaranteed that you'll get your initial investment back," he says. "A bond fund can go up and down, and theoretically never come up again. With an individual bond, you know it's going to mature at face value."

Of his $130 million under management, Brennan figured in May that he had 30% in bonds. In early 2004, he estimates 70% of that bond portfolio was in bond mutual funds and 30% in original issue bonds. More recently, he had swung the other way, keeping 70% of his bond portfolio largely in original-issue agency bonds and CDs due to the expectation of rising interest rates. "I've shortened the terms down significantly. I buy step bonds in initial offering, which are callable at par-somewhere in the area of three, four or five years."

Konstantine "Dino" Mallas, T. Rowe Price fund manager for municipal bond funds, notes that buy-and-hold municipal bond investors needn't fear the price swings of bond funds. But if financial advisors prefer to trade for clients on the secondary market, they need to do their homework to track prices.

Particularly with rising rates, Mallas says, anyone trading municipal bonds also needs to consider the "de minimis" tax rule. If the bond trades below a certain price level, the investor risks owing ordinary income tax-rather than capital gains tax-on the price appreciation.

"Avoid bonds with low original yields," he says. "Look for a higher yield comparable to where yields are today." At this writing, municipal bonds were being issued at 5.15% to 5.20% in the primary market. Also, Mallas advised, go for higher coupons as opposed to lower coupons. "A premium bond is more likely to protect you from having a bond going outside of the de minimis, where it suffers an additional penalty if you go to sell it."