Do It Yourself: Trading Bonds Online - dummies

Do It Yourself: Trading Bonds Online

By Russell Wild

A growing number of financial supermarkets and specialty bond shops now allow you to trade bonds online, and they advertise that you can do so for a fixed price. In the case of Fidelity, the price is generally $1 per bond.

Whoa, you may say. That’s a great deal! Well, yes and no. If that were all that Fidelity and the other middlemen were making, it would be a great deal. But what you see and what you get are two different things. The “flat fees” quoted by Fidelity and its competitors are a bit misleading.

In other words, Fidelity, or Vanguard, or whomever, may charge you “only $1 to trade a bond,” but the price you get for your bond, to buy or sell, has already been marked up from the price that someone else just got to sell or buy. Either your own broker may have marked up the price, or some other broker may have previously done so.

The trading process at Fidelity is similar to other financial supermarkets that offer flat-fee bond shopping. First, you can get good buys on bonds online, but you can also get zapped hard. Many investment pros have had very similar experiences at other financial supermarkets, such as Vanguard and Schwab.

You are most likely to get a fair deal online when you’re buying a bond and dealing in large quantities. You are most likely to get zapped when you’re selling a bond prior to maturity, especially if you’re selling a small number of bonds and if those particular bonds are traded infrequently.

In such cases, you may let go of your bonds for one price and, using TRACE, find out that they were sold seconds afterward for 3 percent (or more) higher than the price you just got. Someone is making very quick money in that situation, and it isn’t you.

If you’re looking to buy bonds

You first choose a bond category: Do you want a Treasury bond, an agency bond, a corporate bond, or a municipal bond? What kind of rating are you looking for? What kind of maturity? What kind of yield?

Most online bond shops walk you through this process step by step; it isn’t that hard. The most difficult piece of the process is making sure that after you know what kind of bond you want, you get the best deal on your purchase.

Here, plain and simple, is what is meant by getting the best deal for a given type and quality of bond: You want the highest yield. The yield reflects whatever concession you’re paying the financial supermarket, and it reflects whatever markup you’re paying a broker.

Comparing yields, however, can be tricky, especially when looking at callable bonds, because you never know how long you’ll have them. Keep in mind that in the past, when interest rates were falling, callable bonds were almost always called because the issuers could issue newer bonds at lower interest rates.

In the future, that may not be the case. So you need to look at two possible scenarios: keeping the bond to maturity, or having it called.

If two comparable bonds — comparable in maturity, duration, ratings, callability, and every other way — are offering yields-to-worst of 4.1 percent and 4.2 percent, unless you have an inside track and therefore know more about the issuer than the ratings companies do, go with the 4.2 percent bond. Just make sure you’ve done your homework so you know that the two bonds are truly comparable.

Fidelity has a neat tool on its website called the scatter graph; it allows you to see a whole bunch of similar bonds on the same graph and what kind of yield each is paying.

The yield reflects the middleman’s cut. Focus on the yield, and especially on the yield-to-worst, to get the best deal. Don’t over-concern yourself with the bid/ask spread on the bond.

When you go to place your order, use the “Limit Yield” option. You are telling the brokers on the Fidelity network that you’ll buy this bond only if it yields, say, 4.2 percent. Anything less, and you aren’t interested. Putting in a “Market” order on a bond can get you chewed up — don’t do it.

If you’re looking to sell bonds

Selling bonds online can be a much trickier business. You have a particular bond you want to dump, and the market may or may not want it.

At Fidelity, you’re best off calling a Fidelity fixed-income trader and asking that trader to give you a handle on what the bond is worth. You can then go online, place a “Limit Price” order to sell, and you’ll very likely get what the Fidelity trader told you you’d get. But here’s the catch: Fidelity itself may wind up buying your bond and selling it to someone else at a large markup.

Truth be told, you are likely to pay a high markup anywhere if you sell a bond before its maturity. Charles Schwab is similar to Fidelity in that you tend to pay through the nose when selling.