Investing in Bonds: What You Don’t Know Can Hurt You

With the recent volatility in the Dow Jones and NASDAQ markets, investor attention has returned to bonds. Today especially, their image of safety, simplicity and consistency is at a premium in many peoples eyes. But this image is a far cry from reality.

Of course many investors realize that bond prices fall when interest rates rise, thus posing some risk to their portfolios. But most investors don’t realize that bond prices also fluctuate depending on their mark up from the seller.

Common Mark-up, Uncommon Cost

Recently a Midwest doctor bought roughly $45,000 in high-grade municipal bonds. He paid $97.41 per $100 bond. Unfortunately, his statement, which arrived several days later, showed their value at $88.78.

After an investigation, the good doctor learned that the major brokerage house which sold him the bonds had marked them up $8.63 each. Now that doesn’t sound like a lot, but it really represented a 9.7% mark-up and loss to him.

Mechanically, brokerage houses actually become the owners of the bonds they sell. While “commission charges” are rare, the brokerage houses mark down prices when they buy from investors and mark up prices when they sell to investors.

You see the “real” market value for the good doctor’s bonds was $88.78, but the brokerage house added $8.63 or 9.7% ($8.63/$88.78), arriving at the price of $97.41 charged to the doctor. This common mark-up represents a very uncommon, or at least very unexpected, cost for the investor.

Since many bonds are added to a portfolio to counter balance some of the stock market’s turbulence, investors will no doubt be quite surprised to learn that they will lose money if they have to sell these bonds in the near- term. At a time (as of this writing) when bond rates are between 6% to 8%, the prospect of losing more than a year’s worth of interest is quite disturbing. So much for safety!

But Everybody Does It!!

When the doctor pressed this issue with the brokerage house, he was stonewalled and told that all brokerage houses do this. When he took the issue to court, the brokerage firm offered as a defense that it shouldn’t be punished for a common, age-old industry practice.

What the brokerage firm knew, along with most professional money managers and securities regulators, was that marking up bond prices to investors was and is quite legal, and has been common practice for quite some time. It’s all part of the negotiation between buyer and seller; only most individual investors don’t know that some serious money is being left on the table.

Pricing information is relatively scarce. The prices of some bonds are quoted in the newspaper, but this represents a minority of all bonds. Dealers have to disclose how much they charge other dealers for bonds, but no dealer has to disclose how much they charge individual investors.

Arthur Levitt, Chairman of the Securities and Exchange Commission, commented in a speech that “investors in the corporate bond market do not enjoy the same access to information as a car buyer or a home buyer or, I dare say, a fruit buyer.”

Unlike stocks where investors can easily determine what was paid for a given stock, there is no central information clearing house for bonds. Investors must rely on a broker for a price quote, which the broker can peg at almost any level. To comparison shop, you would have to ask several brokers for a quote, and most brokers won’t quote until you open an account. So much for simplicity!

Knowledge Is Power

The simple reality is that without readily available comparative information, investors pay a higher price than they should for bonds. As the old saying goes, “knowledge is power” or in this case it’s at least very valuable.

A study done for the Wall Street Journal concluded that the average difference in price for high-grade and high- volume trading municipal bonds among 10 brokerage firms was 2.5%. Another study put the cost at 5%. Even a large corporate buyer like Consumers Union, the publishers of Consumers Report magazine found that its brokerage firm over charged it an average of 4%. So much for consistency!

A Game For Pros, Not Amateurs

To play this game, buyers and sellers must possess the clout to demand the disclosure of all relevant information. Other than the brokerage houses, only professional money managers and the largest institutional buyers have access to this information.

Bonds are not safe, simple or consistent. They do have a place in most portfolios, but only when managed by professionals with proven track records in this investment category.

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