Don't Let Bid-Ask Spreads Scare You From Buying Individual Bonds

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Includes: BAC, BLL, BTUUQ, CHK, CNX, HYG, JNK, LQD
by: The Financial Lexicon

In a recent article, I noted my belief that buying individual bonds is something incredibly misunderstood among participants in the financial markets. In my experience, this is especially true among the general investing public but also true to some extent among money managers. A reader's comment in the aforementioned article reminded me of one aspect of buying individual bonds, especially corporate bonds, about which the public is routinely misinformed: bid/ask spreads.

As I've stated many times in previous articles, when a retail investor purchases individual corporate bonds, I think it would be wise to do so with the intent to hold the bond to maturity. However, just because an investor might have the intent to do something, it does not mean he or she absolutely must follow through. If you do decide to sell an individual bond rather than hold it to maturity, the ability to find a willing buyer at a fair price is certainly something that may become a concern. Depending on the particular security you hold and the overall liquidity in the corporate bond market at the time you wish to sell, you might find it difficult to get a reasonable bid. However, are you destined to take, say, an 8% to 10% hit on the bid-ask spread just because you want to sell a corporate bond at a size considered a retail investor amount? The answer is unequivocally no.

Before I continue with a discussion of some of the things that might affect the bid-ask spread on a corporate bond, I would like to mention the spreads on the five corporate bonds outlined in my article "In Search Of Yield: My Most Recent Fixed Income Purchases" (referred to in my opening sentence). In that article, a reader commented that "if you need to sell any of these issues before maturity you will take an 8% to 10% hit in the spread." The comment didn't surprise me as I've come across this type of thing before in commentaries by market pundits or in casual conversations with retail investors. Hopefully, this article can help to clear up some of the confusion surrounding bid-ask spreads in the secondary corporate bond market.

Let's take a look at the current bid-ask spread on the five bonds in question as well as the most recent dealer minimums on those issues. The dealer minimum refers to the minimum number of bonds that must be bought or sold in the order you wish to enter. Keep in mind that one bond equals $1,000.

In no particular order, here are the five bonds in question:

Peabody Energy's (BTU) senior unsecured note (CUSIP: 704549AH7) maturing 9/15/2020 has a 6.50% coupon and Ba1/BB+ ratings from Moody's and S&P respectively. At the time this article was written, the bid (price at which you would sell) was 3.27% below the ask. The dealer minimum was five bonds.

Chesapeake Energy's (NYSE:CHK) senior unsecured note (CUSIP: 165167BU0) maturing 11/15/2020 has a 6.875% coupon and Ba3/BB ratings from Moody's and S&P respectively. At the time this article was written, the bid (price at which you would sell) was 0.75% below the ask. The dealer minimum was five bonds.

CONSOL Energy's (NYSE:CNX) senior unsecured note (CUSIP: 20854PAH2) maturing 3/1/2021 has a 6.375% coupon and B1/BB ratings from Moody's and S&P respectively. At the time this article was written, the bid (price at which you would sell) was 2.65% below the ask. The dealer minimum was five bonds. As a side note, don't confuse this CUSIP with CONSOL's private placement issued in 2011, CUSIP U20892AC6. They share the same maturity date and coupon.

Ball Corp.'s (NYSE:BLL) senior unsecured note (CUSIP: 058498AR7) maturing 3/15/2022 has a 5.00% coupon and Ba1/BB+ ratings from Moody's and S&P respectively. At the time this article was written, the bid (price at which you would sell) was 0.85% below the ask. The dealer minimum was one bond.

Bank of America's (NYSE:BAC) senior unsecured note (CUSIP: 06051GEN5) maturing 2/7/2042 has a 5.875% coupon and Baa1/A- ratings from Moody's and S&P respectively. At the time this article was written, the bid (price at which you would sell) was 1.47% below the ask. The dealer minimum was one bond.

As you can see, the end of the day spreads from May 1, 2012 on the five corporate bonds mentioned above ranged from 0.75% to 3.27%, nowhere in the ballpark of 8% to 10%. And, keep in mind that these were the end of the day spreads, a time when spreads have been known to widen from where they were at other points in the day.

Peabody Energy and Chesapeake Energy's previously mentioned bonds are two that I've been following for months. At no time have I seen the spread get anywhere close to 8%, let alone 10%. In fact, Chesapeake's CUSIP 165167BU0 routinely has spreads of less than 1%. Furthermore, in my experience, Peabody's CUSIP 704549AH7 normally has a much narrower spread than its current 3.27%, especially when it's dipped below par. In fact, the reason the spread is as wide as it is at the moment is not due to a lack of buyers offering fair prices on the bid but rather due to sellers getting quite aggressive with their offers. I've followed this bond quite closely for a long period of time, and, from what I've seen, the dealers appear eager to buy whatever they can and have been offering very fair bids. However, they haven't been willing to give up the bond very easily and have therefore offered, at times, very aggressively priced asks.

In terms of the CONSOL Energy, Ball Corp., and Bank of America bonds, those were issued in the first quarter of this year, and I have followed them from the beginning. Similar to my experience with the Peabody and Chesapeake bonds, at no time have I witnessed the spreads get anywhere close to an outrageous 8% to 10%.

With that said, just because the spreads aren't wide at the moment doesn't mean it couldn't happen in the future, especially during periods of extreme market stresses. But, let me make it clear that the norm is to not have 8%+ spreads on these five corporate bonds. Absent a market-wide drying up of liquidity, an investor would have to try really hard and even then find it difficult to succeed in selling those bonds at an 8%+ spread to the asking price.

Perhaps it could be possible if you have a broker marking your bond up or down by incredible amounts, but it's not necessary to subject yourself to that in this day and age. I know some people do, and I touch on this topic in my article, "Are You Paying Too Much For Your Bonds?" However, if you stick with firms such as Vanguard and Fidelity, you can avoid the huge markups and markdowns other brokers employ. At Vanguard, you'll even be able to buy those dealer minimums of one bond as Vanguard has now gotten rid of minimums on its customer orders in the secondary corporate bond market.

Finally, it's important to keep in mind that not all corporate bonds have narrow spreads. Some will in fact have 8%+ spreads, and it's prudent to do your homework ahead of time so that you know the liquidity generally offered in the bond in which you are interested. Furthermore, if you don't see any bids at the time you are buying a corporate bond, that should be one clue that it might be tough to get a fair price if you decide to sell before maturity. Also, if the bond you are purchasing is a smaller issue with just a couple hundred million dollars worth of outstanding bonds, that might, although not necessarily, be a clue that liquidity at a fair price could be tough to come by. Last, please don't forget that times of market stresses can cause all sorts of turmoil in bid-ask spreads. This is not just true in corporate bonds but across the spectrum of financial securities.

I hope I've helped to clear up some of the confusion surrounding bid-ask spreads in the secondary corporate bond market. Moreover, I hope that I've made it clear that just because you purchase an individual bond, you are not destined to take massive hits on supposedly outrageous bid-ask spreads. This is true both in the high-yield (HYG, JNK) and investment grade (NYSEARCA:LQD) markets. If you do your homework, you will likely find plenty of bonds that offer what you consider an adequate bid-ask spread.

Disclosure: I am long BTU.

Additional disclosure: I am long the following CUSIPs mentioned in this article: 704549AH7, 165167BU0, 20854PAH2, 058498AR7, and 06051GEN5.