Radical Guide to Online Bond Investing: 2 Reasons to Think Sunshine Is Coming to the Bond Markets

In June 2004, the National Association of Securities Dealers (NASD), the key regulator in the bond markets, fined 8 dealers over $610,000 to settle a case in which the dealers bought municipal bonds from their retail customers at below-market prices. 

How did the NASD know the prices were discounted to the current market?  The same day, the dealers had later resold the bonds at large price markups.  The dealers did not pay the fair market value for their customers’ bonds, a breach of their duties.

The NASD settlement caused attitudes to change. For the dealers, it signaled that compliance costs would be going higher.  In turn, to avoid these costs and fines, some dealers are now disclosing more of their hidden costs.   

Sunshine is coming to the bond markets in two ways:

  • Trading costs are becoming more transparent.  We like the policy of disclosed pricing adopted by Fidelity last year.  Other notable mentions are HarrisDirect and Ameritrade (although it lacks online bond trading).  To its credit, Fidelity led all other dealers in pulling back the curtain somewhat on trading costs.

The operative word is “somewhat.”  As a Fidelity customer, you will likely pay an undisclosed dealer spread somewhere in your trade.  Even Fidelity acknowledges that it may be making markets --- acting as a dealer and putting in a spread --- through its capital markets group.

  • Online bond trading has taken hold.   It is best described as a multidealer and electronic marketplace, where many hundreds of retail bond dealers trade with each other.  Your online bond trade will likely end up there.  You will buy or sell some bond product to an anonymous, neutral dealer within that electronic marketplace. 

To compete in this market, dealers shave their spreads.  While each dealer hides their costs, the price marked up for dealer costs (the “net price”) to the customer is fought over.  Cost savings in the form of narrower dealer spreads are delivered to the small retail customer. 

Please see the next chapter for more discussion on the growing online bond markets.

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June 3, 2005 | Permalink

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