Investing (Carefully!) in Individual Bonds

Navigating Today’s Individual Bond Market

You often don’t pay commissions when you trade individual bonds (you may pay a small one, as you usually do when you trade stocks). Your broker’s money comes from the spread. 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. We’re sometimes talking lots of bacon here. The bid/ask spreads on bonds can be big enough to make the commissions and spreads 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. 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 fairly 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.

Getting some welcome transparency

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 FINRA’s own: http://finra-markets.morningstar.com/MarketData/

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. The world today is divided more or less evenly between those who know about TRACE and those who don’t. Those who don’t pay a heavy price.

Ushering in a new beginning

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 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.

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.

Dealing with Brokers and Other Financial Professionals

You’re probably better off investing in bond funds rather than individual bonds unless you have a bond portfolio (not your total portfolio, but just the bond side of your portfolio) of, oh, $350,000 or more. Building a diversified bond portfolio — diversified by type of bond, by issuer, and by maturity — is hard unless you have at least that amount to work with. Negotiating good prices on bonds is also hard when you’re dealing with amounts brokers tend to sneeze at.

Investing in individual bonds also requires substantially more work than investing in bond funds. With individual bonds, you not only need to haggle, but you need to haggle again and again. After all, with individual bonds, you get interest payments on a regular basis, usually every six months. Unless you spend the money right away, you need to concern yourself with constantly reinvesting those interest payments. Doing so can be a real job.

Then there’s the risk of default. With Treasuries and agency bonds, you can presume that the risk of default is zero to negligible, and with high quality municipal bonds (munis) and top corporations, the risk is minimal. With many corporate bonds and some munis, however, the risk of the company or municipality losing its ability to pay you back is very real. Even when issuers don’t default, their bonds may be downgraded by the major rating agencies. A downgrade can mean a loss of money, too, if you decide that you can’t hold a bond until maturity. Don’t start dabbling in individual corporate bonds or munis unless you’re willing to put in some serious time and effort doing research.

With these caveats in mind, the first thing you need in order to be an investor in individual bonds is a dealer: someone or some institution to place the actual trades for you — without robbing you blind or steering you astray.

Identifying the role of the middleman

Most bond dealers are traders or brokers who buy a bond from Client A at one price, sell it to Client B at another, leave the office for a few rounds of golf, and then come back to harvest more profits. Sorry, we hate to be cynical, but the money some of these Brooks Brothers cowboys make at investors’ expense is truly shameful.

Some bond dealers are very knowledgeable about fixed-income investing and can help walk you through the maze, making good suggestions for your portfolio. Some are very talented at finding the best buys in bonds and using certain sophisticated strategies to juice your fixed-income returns.

Unfortunately, the way dealers are paid creates a system where the traditional dealer’s financial interests are in opposition to his clients’ interests. The more the dealer makes, the less the client keeps. The more the client keeps, the less the dealer makes. The more the dealer can get you to flip, or trade one bond for another, the more the dealer makes. Generally, the more you flip, the less likely you are to come out ahead.

We don’t mean to say that dealers are bad people, or greedy people; they’re no more so than car salesmen are. We’re only saying that bond dealers are salespeople (some of them fabulously paid salespeople) and need to be seen as such.

Like the car salesman, the bond trader who acts as principal (taking ownership of the bond) is not required to reveal what kind of markup he is making. And you won’t find this information in Consumer Reports. (Fortunately, though, you can find it on TRACE; see the section “Getting some welcome transparency ” earlier in this chapter.)

Some bond dealers today work as agents and charge you a flat fee, an hourly rate, a certain amount per trade, or a percentage of assets under management. A good agent, like a good broker, may know the ropes of bond trading well enough to help you make the best selections and get the best prices.

Agents, unlike brokers, do have to reveal exactly what they are charging you. Alas, whereas an agent is generally better to deal with than a broker (simply because the conflict of financial interest doesn’t exist), a good one is very hard to find. And even if you do find one, agents often must work with dealers to get trades done.

Do you need a broker or agent at all?

You don’t need a broker or agent to buy Treasury bonds. You can do so easily and without any markup on www.treasurydirect.gov .

Municipal bonds and corporate bonds must be purchased through an intermediary; you can’t buy these securities directly from the issuers. Sure, you can loan your neighbor or brother-in-law $1,000 and demand the money back with interest (good luck!), and that’s a bond, of sorts. But if you want to buy and sell marketable fixed-income securities, you must go through a recognized agent.

Going through a financial supermarket, such as Fidelity, T. Rowe Price, or Vanguard, is (generally) cheaper than going through a full-service, markup kind of broker. The supermarket’s pricing, which is a concession or a fee (more or less), not a markup, is perhaps more clear-cut. But the supermarket agents generally hold your hand only so much, and they won’t make actual bond selections for you the way a full-service broker will.

You’ll note that we inject some qualifiers in the previous paragraph, such as “generally” and “perhaps.” We explain why in the upcoming section “Doing It Yourself Online ,” where we discuss online bond trading. The financial supermarkets, alas, sometimes make their way of trading sound easier, cheaper, and more transparent than it really is.

Selecting the right broker or agent

Whether you go with a full-service, markup kind of broker or with an agent, we ask you to do a few things:

Find someone who truly specializes in bonds — preferably the kind you’re looking to buy. If you needed hand surgery, you wouldn’t go to a gastroenterologist, would you? If your dealing in individual bonds is going to be any more profitable than, say, investing in a bond index fund, you need a broker or agent who truly knows and tracks the markets carefully — someone who can jump on a good deal. You don’t want a broker who deals in bonds, stocks, gold coins, and collector art!

Start by asking people you know and respect for referrals. Make calls. Ask lots of questions about a broker’s background, including academic and professional history. Ask for client recommendations. Don’t be shy.
Be on guard. Always. Whenever you find a broker and agree to buy or sell individual bonds, be certain you aren’t paying an excessive markup. Although different people in the investment business have different concepts of what constitutes “excessive,” if you’re asked to cough up the equivalent of more than three months’ interest, that’s excessive, in our opinion. Other financial types have their opinions.
Know a dealer’s limitations. Most bond dealers we’ve known are not the best people to build your entire portfolio. They often have limited knowledge of investments beyond bonds. (And that’s probably a good thing; see the first bullet in this list.) If they deal in stocks at all, they may deal in pricy stock mutual funds that you don’t want — the kinds that earn them a nice commission.

Checking the dealer’s numbers

The later section “Doing It Yourself Online ” covers online bond trading. If you deal with a full-service broker, you won’t have to know every detail about trading bonds online. But we still urge you, at a minimum, to become familiar with http://finra-markets.morningstar.com/MarketData (the website of the Financial Industry Regulatory Authority). On this website, you can plug in information on any bond, and you’ll experience the type of transparency we discuss earlier in this chapter.

If a bond has recently been sold, this website can provide you with lots of information: the bond’s selling price; how it’s been rated by Moody’s, S&P, and Fitch; and its coupon rate, price, and current yield (see Book 4, Chapter 2 ). Another useful site, www.investinginbonds.com , features a nifty bond calculator you can use to plug in the price the bond dealer is offering you (which includes his markup) and see if the yield still makes sense given your objectives and the yields of similar bonds.

To get a bird’s-eye view of the bond market, go to Yahoo! Finance at http://finance.yahoo.com/bonds/composite_bond_rates . The chart you find there gives you a pretty good idea of what various categories of bonds are paying on any particular day. If you’re in the market for a bond, compare the composite yield to the yield you’re being offered. If you aren’t being offered at least as much as the average yield, ask why. The Yesterday, Last Week, and Last Month columns show you which way bond yields are headed. But remember that yield trends, just like the wins and losses of your favorite sports team, can reverse direction quickly.

Hiring a financial planner

Lots of people today, including stock and bond brokers, call themselves financial planners. We suggest that if you hire a financial planner, you seriously consider a fee-only planner, who takes no commissions and works only for you. To find one in your area, contact the National Association of Personal Financial Advisors (NAPFA) at 847-483-5400, or go online to www.napfa.org .

Some NAPFA-registered financial advisors work with you on an hourly basis. Others want to take your assets under management. Know that if you hire a financial planner who takes your assets under management, you typically pay a fee, usually 1 percent a year. We think 1 percent is plenty; you shouldn’t pay more than that unless you’re getting help from that planner that extends to insurance, estate planning, and other matters beyond investing.

If you have a sizeable bond portfolio, a fee-only financial planner who is trading bonds for you can potentially save you enough money to compensate for his fee. Even though the planner will be dealing with a broker, just as you would, planners with numerous clients can bundle their bond purchases, so the broker often settles for a substantially lesser markup.

Here’s an example of this type of savings. Matthew Reznik, a NAPFA-registered financial planner with Balasa Dinverno & Foltz LLC of Itasca, Illinois, explains, “If an individual investor is buying a $25,000 bond for his or her portfolio, the markup can be as high as 2.25 percent. If that bond is yielding 5 percent, that’s a pretty big haircut. If we buy bonds, we buy the same issue in a $1 million piece. In that case the spread would be reduced to 0.10 percent.”

Doing It Yourself Online

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.

“The idea that there are no broker markups is not the case,” says financial planner Matthew Reznik. “No matter who sells you a bond, there is always a spread built in to compensate the broker.” 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. Just don’t kid yourself into thinking that $1 is all you’re paying to trade.

The online trading process with Fidelity is similar to other financial supermarkets that offer flat-fee bond shopping. We explain how it works in the following sections. First, we want to let you know that, yes, you can get good buys on bonds online, but you can also get zapped hard. Many other 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.

In this section, we explain how online trading generally works.

If you’re looking to buy

You first choose a bond category: Do you want a Treasury bond, an agency bond, a corporate bond, or a municipal bond? (For reminders about each category, see Book 4, Chapter 3 .) What kind of rating are you looking for? What kind of maturity? What kind of yield? (Book 4, Chapter 2 contains the goods on ratings, maturity, and 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, and the one we most want to help you with, 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 we mean 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 very often 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.

As David Lambert, founding partner of Artisan Wealth Management in Lebanon, New Jersey, suggests, “When considering callable bonds, be sure to examine whether the bonds are selling at a premium or a discount to the call price. If trading at a premium, consider the yield-to-call first. If trading at a discount, consider the yield-to-maturity first. Both of these will give you your most realistic picture of future performance. You can pretty much ignore just about everything else.”

What he is saying is that the yield-to-call on premium bonds and yield-to-maturity on discount bonds both represent yield-to-worst (or worst-case basis yield ). That yield is what you’re likely going to get, so you’d darned well better factor it into your bond purchasing decisions.

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. You can access it at www.fidelity.com . Click on Investment Products and then Fixed Income and Bonds. Get into Individual Bonds and then select the type of bond you’re interested in purchasing. Enter your parameters to create the scatter graph you need.

To reiterate: 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 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

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, says Dalibor Nenadov, a fee-only financial planner with Northern Financial Advisors in Franklin, Michigan. “The bottom line for the average middle-class investor is to build a bond ladder, and hold until maturity. Don’t sell before maturity, and don’t try to time rates,” he says. See the following section for more on bond ladders.

Perfecting the Art of Laddering

Bond laddering is a fancy term for diversifying your bond portfolio by maturity. Buy one bond that matures in two years, another that matures in five, and a third that matures in ten, and — presto! — you have just constructed a bond ladder (see Figure 4-1 ).

© John Wiley & Sons, Inc.

FIGURE 4-1: A typical bond ladder.

Why bother? Why not simply buy one big, fat bond that matures in 30 years and will kick out regular, predictable coupon payments between now and then? Laddering makes more sense for a few reasons, which we explain here.

Protecting you from interest rate flux

The first rationale behind laddering is to temper interest rate risk. If you buy a 30-year bond right now that pays 3 percent, and if interest rates climb over the next year to 5 percent and stay there, you’re going to be eating stewed crow for 29 more years with your relatively paltry interest payments of 3 percent. Obviously, you don’t want that. (You could always sell your 30-year bond paying 3 percent, but if interest rates pop and new bonds are paying significantly higher rates, the price you would get for your lousy 3 percent bond is not going to make you jump for joy.)

Of course, you don’t have to buy a 30-year bond right now. You could buy a big, fat two-year bond. The problem with doing that is twofold:

You won’t get as much interest on the two-year bond as you would on the 30-year bond.
You are subjecting yourself to reinvestment risk: If interest rates fall rather than rise over the next two years, you may not be able to reinvest your principal in two years for as much as you are getting today.

If you ladder your bonds, you shield yourself to a certain degree from interest rates rising and falling. If you’re going to invest in individual bonds, laddering is really the only option.

Tinkering with your time frame

Note that as each bond in your ladder matures, you would typically replace it with a bond equal to the longest maturity in your portfolio. For example, if you have a two-year, a five-year, and a ten-year bond, when the two-year bond matures, you replace it with a ten-year bond. Why? Because your five-year and ten-year bonds are now two years closer to maturity, so the average weighted maturity of the portfolio will remain the same: 5.6 years.

Of course, over the course of two years, your economic circumstances may change, so you may want to tinker with the average weighted maturity. That depends on your need for return and your tolerance for risk.

A perfectly acceptable (and often preferable) alternative to bond laddering is to buy a bond mutual fund or exchange-traded fund. This option is the heart of Book 4, Chapter 5 . But whether you ladder your bonds or you buy a bond fund, we caution you that relying only on fixed income to fund your retirement is probably not the wisest path. You should have a bond ladder or bond funds and other investments (stocks, real estate) as well.