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Looking to 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

 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 to 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, MORGAN, B OF A or CITI, 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 times 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 (NYSEARCA: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, but 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.