Bond Market Needs Revolutionary Change For Investors' Sake

I read an article last night about how a couple of different advisors are using bond ETFs and I had a thought about the entire bond market.

If ever there was a segment of the capital markets that needs to be demystified and made more investor-friendly it is the bond market. When I write about investment products and what I'd like to see come to the market, I often use the word "evolution" to describe what is going on with ETFs. I think the bond market needs revolutionary change - not evolutionary.

The bond market in general is huge. A certain issue may or may not be available at any given time, I realize, but the method of price discovery involves placing a phone call looking for a price and getting call back later in the day with a price. If you have to sell, you are never going to feel good about the bid you get quoted.

I am very interested in foreign bonds and have written about them several times, noting that the minimum order size is $100,000 - which makes it tough for do-it-yourselfers to access the space. I think that sort of minimum is totally unnecessary if we are talking sovereign debt.

Even with more esoteric segments of the market, there has to be a way to to centralize inventory so that investors can input parameters through a series of drop-down menus and the search will deliver what is for sale. The investor either likes what he sees or he doesn't.

Schwab Institutional has something like this for US treasuries, munis and certain corporates, but it is a limited inventory. I am talking about centralized inventory. If someone wants five year paper from Chile, they should be able to plug that in, see how much is offered and at what price and be able to buy the amount they want. If they want $10,000 out of $4 million offered, they should be able to do it without getting hosed.

Similar to equities, I think access for narrow exposures could allow for a superior risk-adjusted result. With equities, at least investors can choose individual stocks over ETFs or vice-versa, but with fixed income this is not necessarily true unless they have huge portfolios. If your portfolio is $10,000, you can put into any stock, or stocks, you want and get a fair price - it may not be a good idea, but you have the choice. Not so with fixed income.

Could people hurt their portfolios? Yes. Would be worse than what some folks do to themselves in their equity portfolios? No.

There are probably all sorts of reasons (read excuses) why this can't be done, so I say again that revolutionary change is long overdue - the bond market does not have to be quite so cryptic. At some point, maybe Congress will Sarbanes/Oxley the bond market or maybe better yet the industry will do something before that happens. (To be clear, I am not saying that Congress mandating something is the best solution.)

Comments

[bluesmoke]

Of course you're right. Bonds aren't as sexy, they don't have huge price swings, and the returns are generally boring as compared to stocks. The broker commissions on stocks are easy money in volatile markets. Moreover, the media prices bonds with yield, instead of price, further confusing any relative historical comparison. I would bet 80% of the retail investing crowd doesn't even know the difference between the two (a stock and a bond). There's a lot to be said for diversification, especially when it comes to high yield funds. So yes, something could and should be done, but I doubt it ever will.

2008 May 15 10:12 AM

[jimmy46]

I've always thought the bond market was a dinosaur but wall street doesn't want to change because with this system they can screw investors.

Any good change would result in the spread decreasing,
and they don't want penny spreads like with stocks.

2008 May 15 02:04 PM

[ETFnerd]

The bond market is largely institutional and was not designed for the retail market. Pooling of capital in the form of open and closed funds is how retail investors participate in this market for the most part. This structure serves institutions and retail investors. An bond index fund provides diversification, daily pricing, transparency, and professional management. The structure today works, and it will be a long time before it becomes cost-effective for b/ds, market information providers to overhaul their systems to accommodate simple and cost-effective retail fixed income trading.

It is not clear that do-it-yourself fixed income trading is better than using the services of a professional investment manager in a capital pool. If it isn't better, why build the capacity?

Clearly in equities where both a direct retail and institutional market exist, do-it-yourself does not translate into higher returns. MPT postulates that for a set of risky assets you are better off owning the market or a representative sample and paying a reasonable fee.

2008 May 15 04:56 PM

[adan]

re ETFnerd's comments above: lot of good points; only thing i still don't like is, not owning the bond itself means less opportunity to simply hold the asset to maturity and get face value back

that's a big plus to the real thing, and a real minus to etf's, mutual funds, etc

why not, for a start, allow actual u.s. treasuries to be available for every single 401 in the country?

2008 May 16 12:23 PM

[richjoy]

Good idea...I would think YOU are a member of various associations attend various meetings, and have numerous professional contacts where you have the opportunity to push for such a stock-like market for bonds.

2008 May 16 08:28 PM

[User 151033]

The simple fact is that the bond market isn't centralized as the stock market is. There isn't a bond "exchange." They do not trade like either stocks or mutual funds and probably never will, though some such as debentures and NYSE bonds do. 95% of the bond market is institutional, 5% retail investors. But DYI can nevertheless peruse various bonds, their prices, and yields on several different websites, investinginbonds.com being one of them, and of course they can buy bonds with several online discount brokers. The info's out there; it just doesn't have the hype stocks and funds do.

A bond is far superior to any fixed income or bond etf or fund, in my judgment, because it has a maturity date and you know exactly what your total return will be; bond etfs and funds are in effect perpetuals without either a maturity or call date. Bonds are the risk averse assets that, in the long run, will outperform stocks and allow you to sleep at night, an argument that most retail investors, bombarded as they are everyday by the buzz from the stock and fund industry and their spin doctors, have difficulty believing. Boring old bonds! Not very exciting. Indeed that's their virtue. BTW, global or foreign bonds are very risky for countless reasons. Good luck with that.

2008 May 16 10:58 PM

[ETFnerd]

My feelings are exactly the opposite to the ones posed above. I think (most) bonds are stodgy out-of-date relics of very limited use.

It may comfort you that you can calculate on day 1 how many dollars you will have in day 365, but how much will those dollars be worth? How much purchasing power will you have?

Individual bonds with a fixed coupon expose you to interest rate risk. There is a real opportunity cost here that is often ignored. Even if you buy floaters, you have to be careful that you match the reference rate to your holding period and not to the duration or maturity of the bond. Otherwise you are exposed to reversals in the yield curve. Even if you hold to maturity, there is inflation risk in floaters unless you are holding TIPS or a similar product.

Equities tend to address partially the interest rate and inflation risks as these are baked into the price.

They are sexier for good reason. Bonds are relics that haven't kept up with the times. That's the reason why there has been a bubble-like explosion of credit derivatives - in order to make the risks correspond to those demanded in the marketplace. Default swaps, bond insurance, IR and FX swaps all serve to address shortcomings in bonds.

Lastly, and maybe most importantly, look at the long-term expected return of the asset classes. This is the reason that for someone with assets with a reasonably long investment horizon, bonds cannot compete with equities.

2008 May 19 01:46 PM