Shopping for bonds: a tale of two markets
September 29, 2016 by InvestingForMe
If you’re the kind of investor that doesn’t buy and sell individual bonds because you prefer to own bond mutual funds or exchange-traded funds (ETFs), then you can ignore this article and move on.
But if you do buy and sell individual bonds, keep reading. You’re probably paying too much when you buy, and getting short-changed when you sell.
Most people don’t realize that unlike the stock market, there’s no central organized market place where investors meet to buy and sell bonds. Instead, bonds are bought and sold through one of two types of markets:
- The Over-The-Counter (OTC) market, where the majority of individual investors buy and sell their bonds.
- The Alternative Trading System (ATS) market, which is a newer market structure where bonds are traded in a market that is similar to stock markets in its structure.
Now, what’s the difference between these two markets? Well, a lot, actually. First, the bonds available to buy are far fewer in an OTC market. And, second, the prices are simply horrible – both, the price you pay to buy and the price you get when you sell.
In fact, because of these disadvantages, I never use an OTC market when buying and selling my bonds. But I’ve kind of forgotten that many people still do. And it’s costing them a lot.
You see, because I don’t use the OTC market, I had forgotten all about the disadvantages until I had a recent chat with a good friend about some bonds I was buying. During our chat, she decided to look up some of the bonds for her discount brokerage account, and as she read me the prices, I realized she was paying thousands more than I was.
(Note: I discuss the two markets in greater detail in the ClassRoom section on Bonds - Bond investors need to know how the game is played!)
The numbers don’t lie
The easiest way to show you the differences between these two bond markets is to build a portfolio of 4 bonds, each maturing in different years, to compare the resulting costs of bonds bought on these two different markets.
Before we compare market costs in the following tables, let’s just review the shopping parameters that were used to build this example:
- I searched only for corporate bonds that paid their interest every 6 months.
- I searched for bonds that matured between 2023 and 2026. (These were the maturities I was personally looking for.)
- I assumed the bonds were purchased inside a registered account thus eliminating taxation concerns when buying bonds at a premium. That is, at prices over $100.
- And, during my search, the bank’s OTC market had 110 bonds available for purchase and the small discount broker’s ATS market had 197 available.
Disclaimer: I just have to say that the bonds outlined in the following tables do not constitute a recommendation to purchase. They are simply bonds that were simultaneously offered by the OTC and ATS markets and are used in this article for illustrative purposes only.
The following tables illustrate the resulting bond portfolio.
As you can plainly see, buying bonds from a broker that uses an OTC bond platform is a lot more expensive in these ways:
- I would have $2,433.75 more in my back pocket if I buy my bonds in an ATS market.
- Because I pay a lower price in an ATS market, my actual bond yields are higher. (So, that’s even more money in my jeans!)
- When I use an ATS market, I virtually always have a greater number of bonds to choose from that ultimately gives me greater flexibility to build a stronger bond portfolio (which I also like ☺).
I Just Have To Add: I still think there’s something fishy about the commission costs that OTC brokers charge their customers to buy and sell bonds. This is disappointing because when CRM2 regulations came into effect this year, brokers where supposed to start telling investors exactly what they’re paying to buy and sell bonds. And although OTC brokers have started to show a number for "Commissions", the numbers they are displaying don’t explain the total cost OTC bond investors are paying. In my example above, there is an extra $2,433.75 in costs on the OTC bond purchases that is not explained.
So, what’s a bond investor to do?
If you don’t know what kind of bond market your broker uses, then you should ask. The type of bond market you have access to will depend on your broker's set up. If your broker uses an OTC platform - you're out of luck. You’re stuck buying and selling through the OTC market that they provide.
When they set up their trading platforms, all brokers have a choice as to which platform they provide to their bond-investing customers – the OTC platform or an ATS market. A couple of our big banks’ discount brokers and most of the non-bank discount brokers have already made the switch to an ATS bond market.
With interest rates and bond yields already at historical lows, the average bond investor, like you or me, can't afford to buy and sell on an OTC bond platform. It costs us more to trade and we get cheated with lower bond yields in the process.
So, do yourself a favour. Before you buy your next bond, make sure your broker uses an ATS market. And, if they don’t, maybe it’s time to move your bond investments to another broker.