How to Navigate Today’s Individual Bond Market - dummies

How to Navigate Today’s Individual Bond Market

By Russell Wild

You usually don’t pay commissions when you trade individual bonds, as you do when you trade stocks. Instead, someone called a broker (an individual wearing a fancy suit) usually trades your bonds. A broker buys a bond at one price and sells it at a higher price.

The difference, known as the bid/ask spread, is what the broker brings home. The bid/ask spreads on bonds can be big enough to make the commissions paid on stocks look like greyhound fat.

Once upon a time, and for many decades, commissions on stocks were as fat as spreads on bonds, sometimes fatter. That began to change shortly after Mary Tyler Moore moved to Minneapolis. (Historians who study the 1970s believe the connection is only coincidental.)

In 1975, the Securities and Exchange Commission (SEC) deregulated the stock markets, allowing for open competition and discount brokerage houses. The competition brought prices down somewhat. Internet trading, which allowed the brokerage houses to economize, brought prices down even more.

Within a few years, the money that most people spent to make a stock trade was reduced to a fraction of what it had been. In the 1970s, a typical stock trade cost $100 (about $400 in today’s dollars). Today, a stock trade may cost as little as $5, and rarely more than $10.

And how has bond trading changed since 1975? It’s changed. But it’s changed like men’s fashions change — not women’s. You have to look harder to notice the differences.

Some welcome transparency in trading

Bond trading today is, in a sense, about where stock trading was in the early 1980s. You can still spend $300, $400, or way more on the cost of a single trade. But you shouldn’t have to anymore. Thanks to a system called the Trade Reporting and Compliance Engine (TRACE), bond trading is becoming a bit more like stock trading.

TRACE is a system run by the Financial Industry Regulatory Authority (FINRA) that can be accessed through many financial websites, such as InvestingInBonds.

Because of TRACE, bond trading no longer has to be a muddied affair in which individual investors are at the mercy of brokers. This system ensures that every corporate bond trade in the United States is reported, and the details appear on the web. (The Municipal Securities Rulemaking Board runs a similar system for municipal bonds.)

TRACE ensures that trading costs are no longer hidden, bond yields (greatly affected by the bid/ask spreads) are easy to find, and good information is available. Among investment people, access to information is generally referred to as transparency. TRACE provides some pretty amazing transparency.

Unfortunately, not everyone knows about the TRACE system, so not everyone realizes that she can find out — for free — the price a broker paid for a bond. In fact, lots of people don’t know. Those who don’t, pay a heavy price.

A new beginning for bond trading

The new transparency, ushered into practice between 2002 and 2005, has removed much of the mystery from bond trading. You can now go online and, provided your Windows system doesn’t crash that particular day, quickly get a pretty good idea of how much a single bond is being bought and sold for — by brokers, institutions, and individuals.

You’ll also see how far a broker — your broker — is trying to mark a bond up, and exactly what yield you’ll get after the middleman and all his cousins have taken their cuts, should you purchase that bond.

Unfortunately, the cuts taken on bond trades still tend to be too high, and you can’t (except in rare circumstances) bypass the middlemen. But with some tough negotiating on your part, you won’t make them terribly rich at your expense, either.