Looking to Invest in Bonds in Troubled Times? Caveat Emptor!

There is a place for income and stability in troubled times. You may be considering, as we do, US Treasuries and other sovereign debt, corporate and municipal bonds, convertible bonds and preferred shares, traditional preferreds, master limited partnerships (MLPs) and high-yielding common shares where the firm’s dividend is well-covered.

If Monday’s 289 point decline has you looking to leap to the safety of bonds I agree – but I suggest you consider doing so via ETFs and closed-end bond funds selling at a discount. Many websites provide information regarding bond funds’ premium or discount to NAV. The one I use most frequently is www.etfconnect.com.

When it comes to the first four above, Treasuries, corporate, municipal and convertible bonds, unless you are regularly buying and selling at least 100 bonds at a time, I believe you are best served in bond funds and ETFs. Why? My last job before I retired from the corporate world and began Stanford Wealth Management was as head of Fixed Income for Charles Schwab & Co. Let me try to shed some much-needed light on how the arcane world of bond trading works.

Bonds are much in the news of late, if only because brokerages and banks with bond trading desks declared outsized profits from those operations in Q1 2009. Remember, when they make gigantic profits, they have to come from somewhere – often from your pocket and mine.

Of course, one reason their bond trading desks did so well the first quarter is that it was pretty much the only game in town. The IPO market might as well not have existed in Q1 2009, M&A activity was moribund at best, the equities markets whipsawed traders mercilessly, and the first 9 weeks of the year had a decidedly downward bias in the equities markets, with a concomitant flight to safety as investors clamored for bonds. Fish gotta swim, birds gotta fly, and traders gotta trade. So they traded bonds. While that fear-induced buying may have been a relatively unique occurrence, trading in the bond markets is hugely profitable for these institutions in any market. Here’s why – and why you should probably avoid buying bonds directly.

Much of the volume in stocks takes place on the exchanges rather than OTC. Almost all of the trading in bonds takes place OTC rather than on exchanges. The exchanges are “auction” marketplaces where a stock will trade at the price which reflects the highest price a buyer is willing to pay and the lowest price at which a seller is willing to sell. The prices hit the tape in a nanosecond or two for all to see. Lots of transparency induces tighter markets.

The OTC markets, however, are “negotiated.” Bond XYZ trades at whatever the market will bear, and is completely unrelated to the price it sold at a nanosecond earlier between two other parties. So it might trade between two parties at 94.20 (bond prices are quoted as a percent of par, so 94.20 would equal $942 per $1000 face value bond,) and a second or a minute or an hour later, the same bond, which hasn’t traded in the interim, might trade for 96.95 between two other parties. In both cases, one of the parties is typically a bank or brokerage bond trading desk. So the bank or brokerage may well buy “for its own inventory” at 94.20 and sell it 10 seconds later to a different client at 96.95.

The lack of transparency, centralized execution and timely reporting typically means that those with the most information (like “too big to fail” institutions with massive computing firepower and the speediest connections) and the most inventory (like “too big to fail” institutions with the most clients selling and buying these bonds) can create wide spreads between the bid and offer price. And big spreads mean big profits. If Goldman (GS), Morgan (MS), B of A (BAC), or Citi (C) , for instance, can take 100 bonds into their own inventory at 94.20 and sell them 10 seconds later at 96.95, they pocket a cool $2,750. Do this thousands or tens of thousands times a day for 12 weeks and you can see how, by acting as “principal” rather than as “agent,” they can make buckets of money.

When you read that one of these firms “traded for its own account” you might think it means they traded these bonds with other institutions, which can be true – but it is only part of the truth. When brokers and banks deal with each other, as for instance when Citi sells $100 million of bonds to iShares for their 1-3 Year Treasury Bond Fund (SHY) or TIPS Bond Fund (TIP), the principals are two professional insiders with their finger on the pulse of every basis point (1/100 of 1%) change in the market. As a result the spreads in these transactions are much tighter.

That’s why I typically buy bond funds and ETFs rather than individual bonds. The professionals dealing in size tend to enjoy the honor among thieves that derives from the fact that the brokerages and banks know the ETFs and bond funds are good for lots of (low-margin but) steady continuing business -- if the broker treats them right.

However, big-profit (to the trading desk) trades take place tens of thousands of times a day with individuals and smaller corporations and pension funds, where the “best price available” is whatever your broker tells you it is. So when you hear, say, that “B of A’s Merrill Lynch subsidiary, trading for its own account” made $1.2 billion this quarter, realize that those tens of thousands of trades by individuals are also counted in the “for its own account” department, even if they were in the bond department’s account for only one second or one minute.

If a bond trading desk bought and sold just 40 bonds a thousand times a day, they’d make $66,000,000 in profits “for their own trading account” for the 60 business days in a typical quarter. But of course they typically trade many more than 40 bonds at a time; a smaller company or pension fund might trade 1000 bonds. And while the trading desk might make less than the $27.50 per bond I use in this example, they often make more. They have an incentive to get as much as they can for the firm -- their bonus depends upon it.

I think charging $1100 to handle 40 bonds, as in the above example, is usurious, Yet I have been a counterparty to transactions where I have seen them attempt much worse. That’s why I choose to invest in bonds via the institutions the brokerages want to keep happy and therefore charge less -- like closed-end funds selling at a discount or ETFs. Bonds and other high-income securities can create an anchor during rough seas – just don’t pay for a gold-plated anchor when stainless steel will serve you better.

Disclosure: We are currently long Advent Claymore Convertible Securities & Income Fund (AVK), which sells at a 10% discount, and bond ETFs TIP and SHY. We own others but have been actively liquidating long positions for weeks into this rally. These three, however, we will most likely keep even after we’ve gotten mostly into cash. They will add stability and income to our pilot positions in inverse ETFs QID, EEV, SDS, SKF and SRS.

Comments

[logicalthought:]

>>My last job before I retired from the corporate world and began Stanford Wealth Management...<<

Good column, but the "physical resemblance" (at least according the picture being used here) to you-know-who is startling... At least shave the mustache!

Apr 22 06:37 AM

[Toeser:]

The author is generally correct, but you do not need to be deterred from investing in bonds as an individual, particularly if you limit your purchases to bonds you will hold to maturity. Learn how to use the tools on www.finra.org/Investor... where all bond trades are reported. Build a watchlist. Then you will know how much your broker is trying to take and you can negeotiate. But even better is to look for a broker that trades bonds for a commission and not on a principal basis. I generally pay around $100 commission for a $20,000 - $50,000 bond trade.

Apr 22 08:16 AM

[delbmarcs:]

I was wondering about this, and sadly, lost another few grand to the sharks while I did so. Thanks for confirming my fears.

My discomfort with bond funds is their instability. I hold bonds until maturity. In bond funds, I feel like I am playing the market again 9which I don't want to do) because they go up and down with interest rates and confidence. How can I get the low cost of buying a bond in bulk while the steady i8ncome of holding them until maturity (without caring about the price of the underlying security)?

To me, the closest thing I can think of is a guaranteed income fund from an insurance company. But I don't have confidence in them anymore.

Apr 22 08:21 AM

[Delojozafado:]

The author mentions closed end funds. I will put forward some of the likely suspects. The WIA has significantly outperformed the TIP over the last 6 months in both yield and price. Same great TIP bonds at a 3% discount to what TIP sells for. As far as general bond funds be wary of the otherwise very good BDF or ICB as they hold a lot of longer term maturities. If you were to own them you should have some TBT in place at a purchase price target below $44.50. Despite all of "their " efforts "they" are just not able to knock the TBT down below $45 and keep it there for more than a day. As an alternative to BDF & ICB one might consider DUC on dips below $11. The "DUC" of death has mostly utility issuances of mostly med term maturities. One other medium term fund is MIN and it is diversified into foreign developed nation sovereign debt. It has shown a great deal of resilience in terms of maintaining it's share value in a fairly narrow range. The LQD has also of late become of interest. IT recently increased the distribution to reflect the fact of what real interest rates now are for liquid investment grade debt. As the price dips on Market sell off days to a yield of +6.5% against it's share price it may be a good bet. The convertibles are interesting and the TSI looks pretty good, but the NGZ like the MIN gives you international diversification. You can see the relative strength of NGZ in a market like yesterday where it was very strong as against the very dangerously 48% leveraged AVK. Just as you get inflation protection with TIP investing and market participation with converts, you may want to improve your chances of holding on to your principle in Bonds with some small positions in AGQ,DGP, and PTM. The precious metals are all in a buying range right now. They could knock off another 10% from here but long term are very strong, just as is the TBT. If you like you can also look into some mega trend Convert preferreds as in CHK-PrD or ADM-PrA. While not of such strong long term trends the HCN-PrG & AES-PrC are also also of interest on pull backs.

Apr 22 08:25 AM

[MinAkkar20:]

Thanks for the column - its nice to see an insider's point of view. You obviously feel that the haircuts taken on individual sales exceed the expenses of ETFs or CEFs. I've often seen what I feel are bargain prices for individual bonds, but as you point out they probably don't match what fund managers are seeing.

Apr 22 08:26 AM

[oldman:]

any relation to the Stanford in the news?

Apr 22 09:55 AM

[delbmarcs:]

Delojoz... - lets' hear more about how to buy and hold bonds, not play the bond casino like we did the stock casino. This is post-apocalypse, or have you forgotten? that's why people are buying bonds. duh.

Apr 22 10:00 AM

[Living4Divi...:]

Excellent article, Joseph. BECAUSE you have a very deep understanding of the bond market, perhaps you can answer a question that has puzzled me:

QUESTION:
It seems that the US Bond market (25T on 2006) is much larger than than the US Stock Market (appx 17T in 2006). I use the 2006 data because it was back when markets were not in crisis. Even if foreigners held 5T in US Bonds, it would show that US investors held appx 20T in bonds and 17T in stocks. This equates to appx 45% allocation to stocks. However the golden rule has been touted as 60% stocks, 40% bonds. This is is mainly followed by pension funds. As well, it is common wisdom that most individual investors are heavily weighted to stocks. Some very large players must be significantly overweight bonds. I assume insurance companies and state/local governments. This begs the question:

Who is over-allocated to bonds?

Do you know where I can look at this data ?

Apr 22 10:11 AM

[mktcycler:]

investinginbonds.com reports for free the same NASD TRACE recent sales data on bonds as most institutions can get on their expensive Bloomberg machines. Nonetheless, the author is right that it is difficult for smaller accounts/individuals to achieve adequate diversificiation without using a fund. A fund is also FAR more time-efficient. Then again, why would anyone even want to be in bonds right now? The yields suck, even in corporates. Equities are the place to be at this point in the cycle (we are at or near to the beginning of a new bull) . And at the end of the upcoming bull cycle, to the extent that you can identify it, you want to be rotating/legging into a mix of defensive stocks (MCD, FDO, ROST, KO, et al) and 30-yr Treasuries. Yes, the game is just that simple...

Apr 22 11:00 AM

[Alan Young:]

Excellent article, and answers some questions I had about bank earnings. Thanks!

Apr 22 11:33 AM

[Joseph L. S...:]

"you-know-who" ?????
I don't believe I look a bit like Voldemort! //grins//

> Good column, but the "physical resemblance" (at least according the picture being used here) to you-know-who is startling... At least
shave the mustache!

Apr 22 04:08 PM

[Joseph L. S...:]

THANK YOU for your comment, Toeser. You are correct -- if you hold to maturity they can only get you on the buy side. There will be no shenanigans on the sell side. Also, most discount brokerages will seek bonds for just a $5 or so commission per bond. Regrettably, they don't carry inventory so they are often at the mercy of bond trading desks as well...

On Apr 22 08:16 AM Toeser wrote:

> The author is generally correct, but you do not need to be deterred from investing in bonds as an individual, particularly if you limit your purchases to bonds you will hold to maturity. Learn how to use the tools on www.finra.org/Investor... where all bond trades are reported.

Apr 22 04:15 PM

[MIKETRADER:]

Corp bond spreads have blown up, while you can get a bid at 60 pts the same broker is offering you that same bond at 70 pts.... so the dealers buys it from you at 60 and sells it 10 minutes later a 70 add 4 times leverage and you made 60% on invested assets.... thats why this vultures made so much money last quarter the benefitting on this spreads.....

Having said that, there alot of opportunities for wealthy individuals on single senior unsecured financials bonds and even senior subordinated bonds (most of the yielding north 8% and at 20% or more discount from PV), from MS, GS, JPM, even BAC and CITI senior bonds look attractive at the actual discount prices.... just dont go to long on maturities, 5 to 10 yrs mts have decent liquidity and should surge in price once uncertanity on the markets diminish and credit spreads narrow.....

Apr 22 04:55 PM

[Joseph L. S...:]

On Apr 22 09:55 AM oldman wrote:

> any relation to the Stanford in the news?

Assuming you are referring to "Sir" Allen Stanford, the Texas/Antigua banker accused of running a Ponzi scheme by the SEC, and not the university or any of some other 15,000 Stanfords, NO. Herewith, a not entirely without tongue in cheek comparison of our two firms…

Allen Stanford of Stanford Financial Group…
Organized in Antigua, one of the more “liberal” islands for lax banking laws

Joe Shaefer of Stanford Wealth Management LLC…
Disorganized at Lake Tahoe, and subject to lifelong SEC, NYSE, FINRA, State of Nevada and peer review scrutiny

Allen Stanford of Stanford Financial Group…
Knighted in Antigua, not England. Gained his title of “Sir” Allen by spreading joy and Franklins around Antigua -- which gave him a title and passport in return

Joe Shaefer of Stanford Wealth Management LLC…
Got his titles (Private, Lieutenant, etc.) the old-fashioned way. Earned ‘em. Some in spots slightly less idyllic than Antigua.

Allen Stanford of Stanford Financial Group…
A dual citizen of the US, where he was born, and Antigua, where he plied his trade until the US Attorney asked him to not leave the US.

Joe Shaefer of Stanford Wealth Management LLC…
An American and proud of it. I don’t need no steenking “escape” passport.

.
Allen Stanford of Stanford Financial Group…
Owns the Stanford Superstars, Antigua’s cricket team and, according to the company’s website, also sponsors Vijay Singh and many other professional golfers.

Joe Shaefer of Stanford Wealth Management LLC…
Once played cricket on Barbados. Watches golf occasionally, but would rather ski, kayak, mountain bike, etc.

Allen Stanford of Stanford Financial Group…
Claims to have assets under management of $50 billion. Unfortunately, some of that may have been garnered from new investors wowed by hypothetical returns presented as if they were actual returns. (This according to former employees who FOR YEARS tried to get the SEC to investigate, all to no avail. Note to SEC: How many employee affadavits does it take to get you out of your offices to check out FRAUD? Can you spell P-O-N-Z-I??)

Joe Shaefer of Stanford Wealth Management LLC…
Stanford Wealth Management has a slightly lesser amount of assets under management. On the other hand, our assets are real.


Allen Stanford of Stanford Financial Group…
Personal fortune estimated by Forbes at $2.2 billion.

Joe Shaefer of Stanford Wealth Management LLC…
Inexplicably, Forbes neglected to include Joe on the most recent list of US billionaires. I’ll contact my friend Steve Forbes and see what the problem is.

Allen Stanford of Stanford Financial Group…
“Sir” Allen is separated from his wife and six children, but has a girlfriend, Andrea Stoelker, he may or may not have been with for 7 years. He may or may not have fired her recently from her “job” as president of the Stanford Super Series (Caribbean cricket) after she did or did not have a “liaison” with Chris Gayle, the captain of the Stanford Superstars cricket team and a somewhat more athletic specimen than Sir Allen. He (Stanford, not Gayle) was also recently the defendant in a paternity suit in Miami, the plaintiff with whom he may or may not have had two additional children.

Joe Shaefer of Stanford Wealth Management LLC…
Positively boring by comparison. He’s been married to the lovely and talented Heather Williams for 14 years. Ms. Williams has also been thoroughly reviewed and registered with the SEC, the NYSE, the NASD, etc., etc. She is the Chief Compliance Officer of Stanford Wealth Management, LLC, and keeps its books, records, and policies in complete conformity with all regulatory rules and guidelines. I’ll bet right about now, “Sir” Allen wishes he had someone like Heather to keep him from having to hire fancy-pants lawyers to defend him against angry investors. You have chosen poorly, grasshopper.

Does this answer your question, sir?

JS

Apr 22 06:32 PM

[Joseph L. S...:]

On Apr 22 10:11 AM living4dividends wrote:
QUESTION: It seems that the US Bond market (25T on 2006) is much larger than than the US Stock Market (appx 17T in 2006)... Even if foreigners held 5T in US Bonds, it would show that US investors held appx 20T in bonds and 17T in stocks. This equates to appx 45% allocation to stocks. However the golden rule has been touted as 60% stocks, 40% bonds. This is is mainly followed by pension funds. As well, it is common wisdom that most individual investors are heavily weighted to stocks... Who is over-allocated to bonds? Do you know where I can look at this data ?

THANK YOU for an excellent question. The short answer is comprised of a few pieces...
that foreign nations and sovereign wealth funds hold more than $5 trillion in US assets and many of them are proscribed from owning equities.

Apr 22 06:48 PM

[Joseph L. S...:]

CONTINUED FROM ABOVE...

On Apr 22 10:11 AM living4dividends wrote:
QUESTION: It seems that the US Bond market (25T on 2006) is much larger than than the US Stock Market (appx 17T in 2006)... Even if foreigners held 5T in US Bonds, it would show that US investors held appx 20T in bonds and 17T in stocks. This equates to appx 45% allocation to stocks. However the golden rule has been touted as 60% stocks, 40% bonds. This is is mainly followed by pension funds. As well, it is common wisdom that most individual investors are heavily weighted to stocks... Who is over-allocated to bonds? Do you know where I can look at this data ?
>
In addition, many US institutions are proscribed from holding "risky" investments like equities. Insurance companies that need to pay out benefits must be able to depend on the cash flow certainty of bond interest.

States and municipalities need a place to park funds both short- and intermediate-term. "The credit5 markets" consist of short-term commercial paper, debt swaps, and T-bills, not just ten- or twenty- or more year bonds. There are trillions in "credit" instruments that are used to settle week-to-week transactions.

Many institutional investors want / need the certainty of payback at maturity so they heavily weight their portfolios with bonds. If you have a defined-benefits program and you know you have 10,000 employees retiring in 20 years, you'd be a fool not to have the bulk of your investments to secure those payments in something you believe will still be there.

Would you rather be a creditor to a company or an owner? Creditors get paid off at some percentage of principal; owners are told those are the breaks. Some ownership is prudent but for many institutions, they'd be sued into submission if they didn't follow the "prudent man" guidelines. They might make better returns in equities but the legal fees would kill them.

Finally, what's good for the goose is decidedly NOT good for the gander. Most of the pension funds et al invest far more in bonds than in stocks -- even as they advise YOU to consider a 60/40 split as most appropriate for people still in their working years. Others advise 100 minus your age to be in bonds.

As to where you can get this data all neatly wrapped with a bow -- you can't. But spend a day on the various .gov websites, especially treasury.gov, and you'll come close!

Personally -- I'd rather buy stocks and for my income component, I'll own convertible bonds and convertible preferreds, high-yielding natural resource MLPs and the stocks of a few great utilities in high-growth regions that I bought when their yields were low but growing. I'm more 85/15 today -- and when the bear goes into hibernation it'll be more like 95/5...

Apr 22 07:06 PM

[BoneYard:]

Couple thoughts: Some bonds trade at $25 par and are exchange traded so they make sense for retail investors - obviously check the yield relative to treasuries. Buying $1000 par bonds from brokers is a great way to lose alot of money - I had Schwab tell me Ford bonds traded on top of treasuries! After they gouge you on the buy price, they will smack you on the sell price - you can bet that will be at market! For institutions and smaller corporations, there is TRACE pricing which will show where a bond priced the last time it traded. The author is correct however that a CEF or ETF makes sense if you are making a macro bet.

Apr 22 09:54 PM

[Sunil Shah:]

Hello Joseph (and I like your moustache!) I am very interested novice in bond funds- the desperately low money market rates warrant it! Question: what do you think of the following ARK PSL. I guess my criteria should be discount to NAV and the fee ratio. Any other criteria you would recommend?

Another important question: I am a non US resident. If I buy the fund via your former employer (ie your mate Charlie Schwab), is the distribution taxed at source (at the 15% rate?) or does the recipient receive it gross.

Thank you for your time

Apr 23 05:36 AM

[Living4Divi...:]

Joseph - Many authors on SA ignore comments/questions to their posts. So a big "thank you" for your generous reply.

Apr 23 07:21 AM

[Joseph L. S...:]

Question: what do you think of the following ARK PSL. I guess my criteria should be discount to NAV and the fee ratio. Any other criteria you would recommend?

YES. Safety of principal. I note that ARK allocates about 50% of its portfolio in floating rate loans, which are usually non-investment grade. The rest seem to be in relatively senior corporate bonds. For me, personally, I wouldn't allocate much to ARK because I prefer a little less yield -- or the same yield if the purchases are better-timed -- and more safety.

PSL is the sector many advisors suggest buying for "defensive" reasons. I don't. I believe if the Bear is severe enough, EVERY stock gets taken down. Hence my preference, if I believe a serious decline is coming, for inverse ETFs and VERY well-selected deeply-discounted high-yielding securities...

And for the tax issues for a Canadian citizen, you'd have to consult a CPA. They seldom understand investing, and I certainly don't understand the tax laws!

Apr 23 06:33 PM

[Joseph L. S...:]

On Apr 23 07:21 AM Living4Dividends wrote:

> Joseph - Many authors on SA ignore comments/questions to their posts. So a big "thank you" for your generous reply.

My pleasure, Sir. And it stimulated me to take a look at your articles, as well, so the communication was worthwhile in both directions, I assure you!
Joe

May 04 09:51 PM