Radical Guide to Bonds: Before You Call Your Broker, Please Read the Following

Advisors usually suggest a 25-30% weighting to bonds as a complement to your equities holdings, as reliable income for the future, or as a tax shelter provided by holding municipal bonds.  Bonds do all that, and probably some more, too. 

The profile of bond returns is typically less variable and steadier than that of equities.  Jim Peterson of Schwab explained this idea in a 2004 article. (See Further Reading.) The Fed raised rates in 11 of the 27 years from 1977 to 2004.  As captured by the Lehman Aggregate Bond Index, the bond markets recorded losses in only 2 of the 11 years of rate hikes.  In the worst year for bond performance, 1994, the losses were a relatively subdued –3%.

Like other investments, the going-in costs matter most.  If you pay too much for an individual bond trade, then you will dampen your ongoing compounded returns.  If you pay too much, then you may have done better by taking exposure to the bond market through a no-load indexed bond fund or a bond exchange-traded fund (ETF).

While trading costs matter, it is hard to find avenues for low-cost trading within the bond markets.  Retail bond investing can be summed up this way:  “The next bond trade will not be televised!”  (Pardon us for reworking Gil-Scott Heron’s line).  You should consider these issues:

  • You have had many good experiences investing in equities.  As exchange-traded investment items, you have seen reasonable bid and ask price spreads on many equities names, including on some fairly obscure ones.  You can find a price quote for your equities in several places and obtain execution in seconds.  Going into a trade, you know how much the trade will cost you.  After the trade, in your trade confirmation, you see all the trading costs (commission, SEC fees, etc.) broken out.
  • The bond market is decidedly unfriendly to small investors.  Outside of Treasuries, U.S. agencies and some of the larger corporate bond issues, you will have a hard time finding price quotes on most items.  If you place a buy order, it may take hours, perhaps even days, to execute.  You will not know the trade costs going in and, to your chagrin, you will not see the trade costs broken out for you after the trade.  (Bond dealers cleverly mask these costs to you.  They hide these costs through what the regulators call “riskless principal trading”).
  • Dealers own the retail bond market.  Keep in mind that only a fraction of bonds (about 10%) are traded on the exchange, unlike the bulk of equities.  To fill a retail bond order, dealers interact with each other to find your bond.  The greater the number of dealers involved in your trade, the larger is the amount of trading costs added to your bond trade.
  • Online and low-cost alternatives for bond investing do exist.  Hope exists.  Since the end of the 1990s, customers and dealers have increasingly traded through online retail bond platforms.  These platforms offer low-cost alternatives and even a peek into the cost structure of the retail bond market.  Additionally, new issue bond programs have sprung up, creating a clean and low-cost way to buy bonds for the long term.

This Guide will show you how online bond trading and new issue programs will save you trading costs.  We discuss online bond trading in detail in our companion guide, Online Bond Investing.  But before that, in the next few sections of this guide we discuss some benefits from bonds and the structure of the bond market.  So please read on.

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June 3, 2005 | Permalink

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