EXECUTIVE SUMMARY

FOR HIGH-NET-WORTH CLIENTS with fixed-income investable assets over $500,000, firms might consider designing customized bond portfolios that meet each client’s unique financial goals and risk tolerance. IN ADDITION TO SERVING THE BEST INTERESTS of clients, CPAs introducing such customized fixed-income portfolios also add value to their firm by broadening the relationship with the client, boosting overall revenue, contributing to stabilizing the firm’s revenue profile and increasing the firm’s ability to compete. CPAs/RIAs CAN CREATE A CUSTOMIZED portfolio for a client by acquiring bonds with stylized characteristics (such as different credit qualities, AMT status and call features) and by choosing either municipals or taxable issues (or both depending on the client’s tax concerns). A FIRM THAT CHOOSES TO BUILD internal infrastructure instead of outsourcing must establish cost-effective relationships with broker-dealers; invest in the managerial overhead necessary to create an operational fixed-income service; and train staff about customized fixed-income portfolios.

STUART ZIMMERMAN, CPA/PFS, is a principal and founder of Buckingham Asset Management Inc. in St. Louis and a managing member of BAM Advisor Services, a turnkey provider of back-office services for fee-only RIAs (www.bamservices.com). His e-mail address is stzimmerman@bamstl.com.

irms seeking to broaden client relationships and increase revenue can meet both objectives by expanding fixed-income services to include laddered and other types of individual bond portfolios. During the past decade, many CPA firms have created fee-only registered investment adviser (RIA) affiliates in their firms or outsourced the function to RIA specialists, building the assets under their management by cultivating investment philosophies that appeal to high-net-worth clients.

In this article, CPAs will find suggestions for offering clients specialized fixed-income platforms. In particular, advisers can offer high-net-worth clients the opportunity to move from bond mutual funds to individual customized bond portfolios. The article also discusses some of the obstacles firms might encounter when introducing new fixed-income services.

ELEMENTS OF A CUSTOMIZED PORTFOLIO
Relying on bond mutual funds usually is the most prudent strategy for portfolios under $500,000, but for larger amounts, firms should consider designing a bond portfolio of individual securities that meet the unique financial goals and risk tolerance of each client.

Bond funds and a portfolio of individual bonds are not the same. If a client invests the fixed-income portion of a 60/40 portfolio worth $2 million in a bond fund with a 0.50% annual fee, the portfolio loses value paying for expenses such as commissions and portfolio turnover. And the bond fund holdings don’t reflect the client’s specific income needs, tax situation and risk tolerance. But a client with an individual bond portfolio through a fee-only RIA typically pays only a charge per transaction for bond purchases and sales. (This does not include any markups or markdowns on the bond price, discussed later in this article.)

There are two broad ways a portfolio can be invested—actively or passively. Active investors assume that the market is generally “inefficient,” so they regularly exploit opportunities when holdings are trading for more or less than they are actually worth. For investors to succeed at active investing, opportunities need to be of sufficient frequency and value to cover the cost of consistently seeking and executing trades. A passive investor, on the other hand, assumes that the opportunities to exploit inefficiencies are too few and far between to effectively pursue. There is a great deal of academic evidence indicating that the collective wisdom of all market players results in highly efficient markets that reflect fair pricing almost instantaneously upon release of any news that might affect a holding’s price.

Adopting a passive approach to fixed income lets firms minimize the management costs incurred by clients. In actively managed fixed-income programs, the portfolio manager attempts to beat the market by trading bonds he or she believes the market has under- or overvalued, or timing the direction of future interest rate movements. In passively managed fixed-income programs, the adviser constructs bond portfolios based on a carefully planned investment policy designed to achieve the client’s long-term objectives. Passive managers achieve their goals by evaluating appropriate bonds that fit particular specifications for that client’s unique fixed-income portfolio, narrowing the final bond selection based on minimizing markups (during buys) and markdowns (during sells), and ensuring sufficient bond quality to minimize the chance for default, calls or other unexpected events that can cause a portfolio to veer off course from its goals.

In addition to serving the best interests of clients, introducing customized fixed-income portfolios can add value to a firm by

Increasing the likelihood that advisers ultimately will direct the majority of clients’ assets.

Boosting the firm’s overall revenue by offering a new service.

Smoothing the firm’s revenue streams from the swings created by equity-only RIAs, which can facilitate capital spending decisions and simplify staffing decisions (such as reducing the need for layoffs during low periods and correctly identifying when to hire for long-term growth).

Increasing a firm’s ability to compete with other local firms that offer individual bond portfolio services.

BUILD A SUCCESSFUL FIXED-INCOME SERVICE
CPAs considering offering individual bond portfolio services must think carefully about the additional costs and regulatory oversight involved in building an internal infrastructure to provide such services.

A firm cannot clone all the staff and processes used for equities onto a new fixed-income service; fixed-income portfolios are fundamentally different. Specifically, three steps are key to the success of a firm that offers individual bond portfolios: establishing cost-effective quality broker-dealer relationships; assuming additional managerial overhead including staffing adjustments and reporting procedures; and supporting staff education and training.

Step One:
ESTABLISH COST-EFFECTIVE RELATIONSHIPS
To expand fixed-income services, your firm must have its own in-house trading department or outsource it to an established fixed-income provider. Regardless of your decision, high-quality broker-dealer partnerships are important, and here’s why: A firm must create enough purchasing power to buy and sell bonds with minimal markups and markdowns. “How do you become an important client [with a broker]?” asks Marilyn Cohen, author of The Bond Bible (Prentice Hall Press, 2000). “Number one, you need to have a lot of money; and number two, you need to do numerous transactions throughout the year.”

If your firm decides to trade in-house, you can expect it to take time to build up the volume to command institutional bond prices with multiple broker-dealers. And it’s costly for a firm to subscribe to a financial information system such as Bloomberg, properly analyze bond characteristics and availability, buy portfolio reporting software to create client report, and obtain legal counsel and insurance.

If your firm outsources to an ally that serves as a liaison between you and the bond broker-dealers, that ally should already have these elements in place, as well as established relationships with multiple broker-dealers. Such an arrangement can help you more quickly and cost-effectively build an established department with strong purchasing power.

Partnering is better than trading directly with broker-dealers for a number of other reasons as well. Chief among them is the fact that if a client’s bond portfolio is constructed with bonds from a broker-dealer, the client likely will pay more for the bonds because of higher markups attached to such bonds. A transaction fee is not the same as the markup on a bond, so the cost of these markups remains unseen by the client. (See Explaining Bond Markups.)

Also, broker-dealers do not use the same compensation model as fee-only RIAs. The fee charged by an RIA is transparent; charging flat fees for a menu of services based on assets under management is a reasonable way of serving a client’s interests. Conversely, a broker-dealer representative works on commission. Commissions produce an incentive for the broker-dealer to buy and sell more frequently and to sell from his or her existing bond inventory, where commissions often are higher.

Step Two:
MANAGE OVERHEAD
Creating an in-house fixed-income service requires the firm to invest in managerial overhead and personnel, including retaining staff with specialized bond knowledge and adding resources needed for added compliance oversight. Staff will be involved with tax-loss harvesting, monitoring the portfolio for credit changes and monitoring interest rate changes that could affect income streams due to the embedded call features in individual portfolios. In addition, the firm will need to establish new reporting procedures for internal execution, settlement and reconciliation, and problem resolution. The firm also must create best execution procedures and processes that cover all aspects of the broker-dealer relationship.

Step Three:
EDUCATE STAFF AND CLIENTS
Whether the firm is managing fixed-income services internally or outsourcing them, it’s vital that firm members communicate effectively with clients about the mechanics of individual bond portfolios. That requires educating staff about fixed income—and then educating clients. Clients who are heavily tilted toward equity in their globally diversified portfolios might be confused when they hear that a bond portfolio includes only high-grade issues and carries no high-yield component. “If it is worthwhile to hold value stocks,” they might ask, “why not follow the same rule and hold high-yield bonds in a bond portfolio?” You and your staff’s ability to answer client questions with confidence adds value to the client-CPA relationship, which can ultimately grow the overall assets under management of the firm.

AICPA RESOURCES

CPE Investment Planning—The Risks and Rewards, a self-study course (# 730818JA). Managing Client Expectations in an Uncertain Market, a self-study course (# 056512JA).

BECOME CLIENT-CENTRIC
Moving from basic fixed-income vehicles to individual bond portfolios can benefit the overall portfolios of many high-net-worth clients. Clients with individual fixed-income portfolios have fewer expenses and interact more often with their advisers than clients who hold bond funds. Before buying any bonds, though, advisers should thoroughly understand the client’s financial situation, financial goals and unique risk tolerance.

To create a customized portfolio for a client, advisers would acquire either municipals or taxable bonds (or both depending on the client’s tax concerns) with stylized characteristics (such as different credit qualities, AMT status and call features). For example, a portfolio should be constructed with bonds that have a higher credit quality (rated A or higher). In general, customizing a bond portfolio allows advisers to determine the timing and magnitude of realizing taxable events and can facilitate overall tax planning.

A client whose portfolio is passively invested can receive all the benefits of a separately managed account (SMA) program minus the expenses that sometimes support active management, such as hiring well-known managers, adding staff to search for bonds that might outperform the market, or purchasing expensive equipment and software for the purpose of timing the market. A high-quality fixed-income component helps clients remain true to well-planned investment policies. Still, advisers should be aware of the costs associated with fixed-income portfolios: the expenses associated with purchasing bonds from a broker-dealer, most notably potentially excessive markups and markdowns which are covered elsewhere in this article.

PRACTICAL TIPS TO REMEMBER

For amounts over $500,000, consider a bond portfolio consisting of individual securities that meet the unique financial goals and risk tolerance of each client and facilitate overall tax planning. To quickly and cost-effectively build an established department with strong purchasing power, align with partners that have specialized bond knowledge and resources in place, and established relationships with multiple broker-dealers. Beware of excessive markups or markdowns and bonds that come from a broker-dealer’s own in-house inventory. Access a service (such as Bloomberg’s) that can provide accurate bond pricing information.

BE READY TO SERVE
CPAs can distinguish themselves with clients via the application of high-quality customized bond portfolios under the appropriate circumstances. Many clients who desire customized portfolios first will look to their CPAs to provide them with individual fixed-income services. For CPAs with RIA affiliates capable of providing them, offering clients alternatives to bond funds and other collective investment vehicles can add value to the client’s portfolio, strengthen the relationship between the client and the firm, and add value to the firm. Even when bond funds are the appropriate solution, clients still can benefit from learning about other fixed-income options available to them; individual bonds might become appropriate based on changes in the client’s financial and life circumstances (such as retirement, change in marital status or inheritance). CPAs who offer client education as an important part of the client-adviser relationship can succeed in enhancing client experiences for the lifetime of their portfolios.

If your clients have existing individual bond portfolios, chances are good they have purchased bonds with excessive markups of which they are unaware. Once made aware, they will want to know how the markups occurred. Discussing markups with your clients will show them how your firm adds value by avoiding excessive costs.

A markup (or markdown) is the difference between the price dealers transact among other dealers and the price the customer pays. When clients see transaction fees on their trade confirmations and portfolio statements, they might assume these are the bond’s only cost. Markups, whether reasonable or excessive, do not appear on portfolio statements, but in reality, the practice of charging them when investors buy or sell bonds is more prevalent than most investors realize.

This exhibit represents a typical bond issue being bought and sold at a variety of prices. All four dealer-to-dealer transactions (identified in the Sale Type column as “Inter-Dealer” transactions) were priced between $98.423 and $98.75, a relatively tight range. In contrast, the highest price a retail client received for selling the issue (Purchase from Customer) was $96.50, about 2% below the dealer price. The lowest price a retail client received when purchasing the issue (Sale to Customer) was $100, about 1.5% above the range of dealer prices. The difference in prices between those at which the retail clients could buy and sell, versus those the dealers paid or received, represent dealer markdowns and markups.

Legal Requirements Regarding Markups/Markdowns
Currently there is no legal requirement that markups and markdowns be disclosed to investors. The Municipal Securities Rulemaking Board states in its General Rule G-30 that prices and commissions for bond transactions must be fair and reasonable, “taking into consideration all relevant factors, including the best judgment of the broker…as to the fair market value of the securities at the time of the transaction.” For the first quarter of 2004, 97 of the 100 most excessive municipal trades included markups ranging from 6.753% to 15% according to Kevin Olson, who maintains a public service information site, www.municipalbonds.com, which advocates fair disclosure of municipal bond disclosure information.

Why So High?
There are at least three reasons why the hidden costs associated with purchasing bonds might be even higher than costs of purchasing stocks: the way bonds are traded, the amount of publicly accessible information available about bonds, and the potential objectives of broker-dealers who hold large in-house bond inventories.

Trades. Bonds traded “over the counter,” where dealers trade with each other, differ from stocks traded on a public exchange. Bond dealers maintain an inventory of bonds, and take on the additional risk of whether they will be able to sell the bonds for more than they themselves paid for them. Thus, they consider reasonable markups to be fair compensation.

Public information. Second, the amount of information available about stocks greatly outweighs information on bonds. Bond prices are not listed in the local newspaper and tracking them efficiently is difficult. There were approximately 2,750 companies listed on the NYSE at the end of 2003, but there were two million separate municipal bond issues outstanding.

Objectives. Finally, bonds quite frequently come from the broker–dealer’s own in-house inventory. In many instances a broker is torn between the competing objectives of reducing the company’s exposure to market risk (from holding an issue in the face of future unforseen interest rate changes) vs. doing a thorough search for a bond that better meets a client’s unique risk tolerance or individual portfolio needs.

Most clients appreciate hearing about markups and how bond transactions occur. When clients know how bonds trade and the real costs associated with such transactions, they become aware of the benefits of working with a firm that has an established fixed-income department with multiple broker–dealer relationships. It can add value to the client-adviser relationship when clients know that their adviser is actively seeking to avoid excessive markups or markdowns while searching multiple sources for a bond that meets their needs.