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Individual Bonds: What The Bond Traders Are Hiding

By: Investor Solutions

By: Investor Solutions

For 3 years I worked on one of the best and largest bond trading desks in Chicago. We had some monster companies as clients like Microsoft, Cisco, Ebay and Amazon. We had the ability to implement various strategies. I had access to limitless information, up to the second news wires, instantaneous pricing software and trade information, and favorable pricing because of our order size. Most importantly this was all at my fingertips, easily accessible and decipherable. We had a wealth of knowledge and years of experience, which is why it comes as a surprise to me why an individual investor would want to dabble in the same market as us. Why do individual investors without all these things buy individual bonds as opposed to just buying a bond mutual fund? I see it all the time though. They take on more risk, pay higher costs, are late to react to a company’s changing financial structure and they are often uninformed about what they are actually holding.

Benefits of Mutual Bond Funds vs. Individual Bonds:

PRICING / MARKUP & MARKDOWN

For most individual bonds the markup when trying to purchase the bond or markdown when trying to sell the bond is very large. Municipal bonds often tend to be the worst because they are lightly traded. With no liquidity it becomes very difficult to negotiate a better price. We recently took a look at an Arkansas State Water, Waste Disposal and Pollution Abatement bond that a client asked us to review. As of this writing the last trade was in late June 2010 (it is now November). Stale quotes like this make price discovery impossible. If you went off the last buy and sell for this bond, your market would be pretty wide. In June there was an institutional purchase from a customer for 99.871 ($100 is par value) and a subsequent sell to a customer for 102.75. That’s very costly if you are an individual trying to trade a bond position. The quotes mentioned above are 3% apart. If you didn’t buy the bond as a new issue you are automatically starting with a 3% loss.

There is usually a 1% – 5% markup on bonds by broker dealers. If you want to sell your bond a broker dealer will mark down the price of your bond, paying you slightly less than the current value. They will subsequently sell that bond at a price above the market value. That means the institution is making money but the customer or individual is losing big. You’re basically at the whim of whatever price the broker dealer you are trading with wants to purchase or sell the bond at. To drive this point home, at the end of this article there is a graph and a chart showing the trading activity. A blue dot is the price a customer was able to buy the bond from an institution or broker dealer and a red dot was the price they were able to sell to this institution. This activity is the norm as opposed to the exception in this marketplace and it forces you into a buy and hold strategy just to make the trade cost effective. If you end up needing the funds before the bond matures, you may be forced to sell anyway. However, another more cost effective option exists for individuals, the fixed income or bond mutual fund (such as those offered by DFA funds such as DFIHX and DFGBX). With this product, individual investors can let the fund company worry about pricing. Bond funds will generally get better pricing because they can offer institutional traders more size and trade more often giving them influence over the people they trade with. Purchasing bond funds also has additional upside because they trade on an exchange and are very liquid. You can get pricing as of the close of the previous day, no guessing about where the market is. All you have to pay is a small trading fee and annual expense ratio that mutual funds carry (around .07% to .40%). Many bond ETFs are now being offered as well, which give you immediate pricing throughout the day and also come with a low expense ratio. These ETFs, like stocks, allow you to see the inside bid and ask spread and how it changes through out the day.

RATING AGENCIES

How important are ratings to fixed income securities? Over the past couple of years we’ve seen that these securities are at the mercy of the rating agencies’ opinions, but how reliable are these ratings? When was the last time they even reviewed the company they are rating? Individual bonds are subjected more to this kind of risk. You may think you are purchasing an investment grade bond when in reality it’s not because the agency just hasn’t reviewed it in awhile. Maybe the agencies’ opinions are skewed by other factors. It certainly has seemed that way these last few years. Just look at how the business model is set up. Corporations pay these agencies to rate their bonds. If they don’t like the rating they simply stop paying them for it. The agencies have a conflict of interest to give out better than warranted ratings. Our Arkansas bond was first initiated with a rating by Moody’s in August 2002 and wasn’t reviewed again until April 2007. The latest current review was April 2010, more than six months ago. With a bond fund you diversify away the specific company risk. You also allow the mutual fund company to take on the responsibility of selecting which securities to include in their portfolio. The time, energy, money and onus is on them to build a quality fund. If you want to do your own research and avoid being at the rating agencies’ whim, your access to information will be very limited unless you have the money to spend on software and programs. Even then you are talking about more costs associated with investing. Mutual Fund desks are equipped with everything they need to make informed, quality decisions at their fingertips. A Bloomberg machine can get you any piece of information you need but they are out of reach to most individual investors.

UNDERSTANDING WHAT YOU OWN

Moreover, some people tend to not fully understand the information they get if they do their homework at all. There is little transparency within individual bonds. Some people might buy the Arkansas bond mentioned above, see that it’s related to a water, waste disposal and pollution abatement facility and think that its payments are based on the revenue generated by this facility. Looking further we see that it is a General Obligation or “GO” bond . There would be a drastic difference in its credit worthiness and quality if it were a revenue bond as opposed to a GO bond backed by the full faith and credit quality of the state. Many individual investors don’t know the difference or think to look at the difference in credit quality between GO bond and a revenue bond. There are lots of other things to consider as well. For instance, the revenue from AMT municipal bonds, though tax-free, is included in an individual’s Alternative Minimum Tax calculation when filing his/her tax return. If not known or considered this could be a huge problem for somebody who is trying to avoid paying higher taxes. There are a host of other problems that catch individual investors off guard as well. For instance, a bond’s coupon rate is not often the yield one will receive once the bond is trading in a secondary market. Investors often aren’t aware of the call or put features of a bond either. It is easy for clients to buy GE stock and have a good idea of what they own; there’s only one stock, but what about a GE bond? There are hundreds of different kinds of GE fixed income securities. Some are subordinate, some are asset backed and some are convertible. Most people don’t know what they own. If you buy a bond fund these problems are simplified. Tax ramifications become easier to understand. A mutual fund profile is much easier to find especially if you’re looking at a large fund like Vanguard or Pimco. All in all, a mutual fund has far more transparency, risk aversion and cost efficiency than an individual bond.

The graph and chart below show price discrepancy between purchases and sales by customers in the Arkansas State Water, Waste Disposal and Pollution Abatement bond.

Bond Trades: Notice price difference between inter-dealer trades & those to customers.

http://www.investinginbonds.com/MarketAtAGlance.asp?catid=32

http://trades.municipalbonds.com/bonds/recent/