How to Invest in Bonds: Taking Control and Avoiding the Fees
By Bill Addiss
Although the bond market in the U.S. is more than twice the size of the stock market, many individuals are not familiar with investing in bonds. Those that are familiar with it often opt to invest in bond funds, but unfortunately, this usually results in incurring commission charges and ongoing annual fees that can be avoided.
With a little bit of homework and knowledge, it is VERY possible for investors to manage this portion of their portfolio and avoid the fees and lack of control. In prior articles we have discussed different strategies for investing in bonds in today’s rising interest rate environment. Here, we will discuss some of the mechanics to investing for the individual investor.
The U.S. Treasury market is the largest and most liquid of the bond markets in the world. Investors globally are attracted to it for the income and safety if affords. The US Treasury offers investments as short as 1 month to as long as 30 years. Thanks to a program entitled Treasury Direct, individual investors are afforded the opportunity to buy Treasury Bills, Notes and Bonds directly from the Treasury Department when they are newly issued. The benefits of doing so include:
- NO commissions or fees
- A schedule of regular offerings allowing for a variety of different maturity options
- Ease: Investors can have the money automatically deducted from bank accounts to purchase the securities
- Investment denominations often as low as $100
- Individual investors receive the exact same price/yield as the largest institutional investors, with no additional fees or ‘mark-up’
- The Federal Reserve Bank offers free custodial services (meaning they hold your securities for you), charging no fees or need for a brokerage account
It is important to note, that should the investor choose to liquidate their Treasury Securities before maturity, they must be transferred out of the Treasury Direct program, put on deposit at a broker/dealer and liquidated in the market. This could potentially incur market risk, as well as fees or commissions applied by the broker which could result in a loss. If, however, you are a traditional buy and hold investor, the securities can be kept on deposit within the Treasury Direct program, incurring no fees or expenses.
The newest type of bonds the U.S. Treasury offers to investors are called TIPS (Treasury Inflation Protection Securities). These are adjustable rate bonds (unlike most bonds here in the U.S. which offer a fixed return). In the current rising interest rate environment, these securities are now particularly attractive. The Treasury Dept. issues these bonds with maturities as short as 2 years, to as long as 30 years.
The schedule of new issue TIPS can also be found on the Treasury Direct website. Additionally, like other treasury securities, TIPS can purchased via the Treasury Direct program, offering retail investors the same benefits as described above. TIPS, however, are only available in $1000 denominations.
Investors seeking income often turn to corporate bonds. These bonds offer a bit more credit risk than Treasury bonds (because you are lending money to corporations, not the U.S. Government) However, unlike stocks, the bond market does not trade on exchanges but rather in the OTC (over-the-counter) market. This means, should investors seek to buy or sell bonds they must go through their broker/dealer.
In the past, this lack of centralization and price transparency meant that investors could not be sure they were getting a fair price. That is no longer the case. Today, individual and institutional investors alike can make sure they are getting fair prices. To explain: The Federal regulator for the U.S. corporate bond market is called FINRA (Financial Industry Regulatory Assoc.). At FINRA.org, it is now possible for investors to check and see where individual bonds are trading in the market and at what price. Through their TRACE portal, investors can also identify where bonds have traded in the marketplace as recently as 15 minutes ago! The impact of this is huge for individual investors. Now, when buying bonds directly through a broker/dealer, you the investor can go to the FINRA website, identify that bond and see where the bond has traded to assure that the price you are being offered for the bond is fair.
Municipal bonds can be extremely attractive for many investors because they offer most individual investors tax free income, unlike corporate bond income which is taxable. The regulatory agency for Municipal bonds here in the U.S. is the MSRB (Municipal Security Rulemaking Board). Like FINRA, they too now offer the opportunity for the individual investor to see if the bond price they are being offered by their broker is fair. At MSRB.org, investors can access RTRS (Real Time Reporting System) and identify a particular bond to see where that bond traded as recently as 15 minutes ago. This, too, is designed to give the individual investor more access to current market information.
Understanding How to Buy and Sell Bonds
As briefly mentioned above, bonds here in the U.S. do not trade on exchanges, they trade in the Over-The-Counter (OTC) market. This means there is no centralized marketplace or exchange to buy or sell bonds. Therefore I might suggest, when working with a broker to buy or sell bonds, you might consider the following:
- Contact a broker you have an account with to explain your needs and get bond suggestions and prices from them.
- Check the price at which they are offering the bonds to you (or willing to buy bonds from you if you are selling) using TRACE for corporate bonds, or RTRS for municipal bonds, as explained above.
- If there is a disparity between the prices shown in those systems and the price you are getting from your broker, shop your business to other brokers.
- Important to remember: Because of the nature of the OTC, it is almost always advisable to shop different brokers to compare prices. This is certainly a bit more time consuming but can be well worth the effort!
Also, due to the nature of the OTC market, many (if not most) broker/dealer firms maintain a daily inventory of previously issued corporate, municipal and government bonds which they willingly offer to their retail and institutional clients alike. As a potential buyer of bonds, check with your broker/dealer, but always remember to check the accuracy of their offerings using TRACE or RTRS.
As this article highlights, it is VERY possible for retail investor to buy individual bonds and reduce, if not avoid, the fees they would have to pay a money manager or fund manager. Granted, a bit more homework may be required, but for those investors seeking to take control of their investments and minimize or even avoid any fees, the opportunity is here. About the Author
Mr. Addiss develops and facilitates educational programs for a variety of major financial institutions, government agencies and foreign governments.