PDV manages fixed-income investments for many clients, providing considerable benefit in how we analyze and shop bonds for them. We have access to the bond inventories of different broker/dealers. We will not commit our clients’ funds unless we believe that the bond prices are fair, which is accomplished by cross-checking prices being offered by different brokers/dealers for comparable bonds. Though shopping bond prices is a very time consuming process, here at PDV we regard it as an important task we undertake to benefit our clients. How does this situation differ from when you buy bonds from your broker?
Many investors might think it is not necessary to hire a professional to manage their fixed-income investments, as they can simply rely on their brokers to feed them attractive bonds for consideration. In this way, investors who don’t have time to study and keep up with the bond market might be lulled into a false sense of security. Often, investors’ due diligence amounts to no more than satisfying themselves with an acceptable credit rating and yield. Consider the following scenario which is quite typical.
Your broker calls up recommending a bond. Many people might be content to ask about the credit rating and yield and then make a decision. But you correctly go further to inquire about liquidity, maturity, tax issues and the existence of any call and other special features. You also know something about the entity that issued the bond, and feel comfortable with its prospects. So you decide to take your broker’s advice and buy the bond. Afterall, what can go wrong at this point, right? Probably more than you think or have been led to believe.
Do you know whether you are being charged a fair price for the bond? Should you care? You should, because an otherwise good bond becomes unattractive if you overpay for it. You might respond that you know (a.k.a. think) the price is fair because you trust your broker. Implicit in this response is the notion that your broker has the greatest (or sole) influence in pricing the bond. This is in fact not true. Assuming your broker is indeed trustworthy, it still does not mean the price is necessarily fair. To understand why, it’s important to examine how bonds are bought and sold.
The bond market is actually a much bigger market in dollar volume traded than the stock market, even though you might have thought the converse is true given the relative prominence of the attention-grabbing headlines on the stock market. While some bonds are traded on the exchanges like stocks, where you get a good picture of fair market prices because trade records between willing buyers and sellers are available almost instantaneously, most bonds are traded “over the counter.” Rather than using a centralized location like an exchange, over-the-counter bonds are traded by brokers/dealers over phone and computer systems.
When you want to buy a bond, several players are usually involved. Each layer of participant adds transaction costs to your trade. When your trustworthy broker approaches you with a bond, he doesn’t own the bond. It is highly likely that the brokerage company (“Brokerage Company”) with which your broker is associated owns the bond (i.e. has the bond in its inventory.)
The bond trader at the Brokerage Company (not your broker) usually has the most influence in pricing that bond based on market conditions and a variety of other factors. Built into the price will be a profit or spread to the bond trader and the Brokerage Company. To compensate your broker for selling the bond to you and answering your questions, if any, about the bond, your broker gets to add a further commission or spread to the price. Depending on what type of bond you’re buying, you may simply be quoted a price for the bond that already incorporates the various layers of transaction costs.
If you instruct your broker to look for a specific bond for you (as opposed to having the broker present a bond to you), and the Brokerage Company does not have it in inventory, the situation becomes even more complicated. This is because your broker has to rely on his in-house bond trader to search for the bond from third party brokerage companies that have it in inventory. Assuming the bond is found, the third party brokerage company will itself build in yet another spread. By the time the bond is finally offered to you, there will be three separate profit components built in!
While limited space doesn’t allow a detailed analysis of the reasonableness of each of these profit components here, suffice it to say that the profit charged by the brokerage companies should bear a reasonable relationship to the risk level of the bond. This is because the brokerage company that has the bond in inventory bears the risk that the bond value will decrease pending sale to some other person or entity out of inventory. Your broker, who doesn’t bear this risk because she doesn’t actually own the bond, should be compensated on a different basis than the risk level of the bond.
As may be apparent from the foregoing discussion, even if your broker is trustworthy and charges reasonable compensation for his services, this does not mean the other player(s) (e.g. his in-house bond trader) will be as reasonable. Since your broker as a practical matter will have a difficult time getting the in-house bond trader to divulge the amount of her profit, your broker is not likely to be in a position to “police” his own in-house trader.
Unfortunately, there is no simple, quick way to verify that bond prices are reasonable. Generally, the verification process involves having access to several broker/dealers and the prices they are quoting for same or similar bonds. This process is complicated by the fact that prices can change during the day. Also, different brokerage companies will generally hold different bonds in inventory. More often than not, determining fair prices for bonds would first involve deciding what qualify as comparable bonds, so price and yield comparisons can be made on an apples-to-apples basis.
As you can see, buying bonds can pose many pitfalls. The unwary or those who don’t have the knowledge or the time to shop bond prices should know that the potential for pricing abuse is huge. This is not a hypothetical or theoretical concern, but one that can cost the unwary investor a lot of money (as unreasonable transaction costs can severely erode the yield of a particular bond.)