The Bond Market: Where The Customers Still Have No Yachts

by: Matthew J. Patterson

Last year, I published an article on Seeking Alpha that employed data from a single day of bond market trading to quantify the significant transaction costs incurred by retail investors when trading individual corporate bonds. One unanswered question concerns how the costs of trading individual corporate bonds for retail investors compares to the costs incurred by institutional investors to trade the same bonds.

Unlike equities, which generally trade on exchanges where retail investors enjoy comparable trade execution to their institutional counterparts, most bonds continue to trade in an over-the-counter market. In the over-the-counter bond market, access to pricing information and the quality of trade execution depends heavily on maintaining relationships with multiple bond dealers who will provide competitive bids and offers to trade particular bonds. Institutional investors typically maintain relationships with larger networks of bond dealers than retail investors, thereby enabling them to gain greater access to pricing information and obtain more favorable trade execution when trading individual bonds.

Accretive Asset Management (“AAM”), sponsor of BulletShares Indices, recently published a white paper that quantifies the markup paid by retail investors to trade individual bonds. Based on a full year’s worth of data compiled from FINRA’s TRACE database of corporate bond transactions, AAM estimates that retail investors pay a round-trip retail markup of 65 basis points (0.65%) on average to trade the same corporate bonds as institutional investors.

Quantifying the Retail Markup to Trade Individual Bonds

To determine whether retail investors receive less favorable execution in the bond market than institutional investors, we evaluated all transactions reported to the TRACE database during 2010 for securities contained in the following BulletShares USD Investment Grade Corporate Bond Indices (the “BulletShares Indices”):

  • BulletShares USD Corporate Bond 2011 Index (NYSEArca: BSCB)
  • BulletShares USD Corporate Bond 2012 Index (NYSEArca: BSCC)
  • BulletShares USD Corporate Bond 2013 Index (NYSEArca: BSCD)
  • BulletShares USD Corporate Bond 2014 Index (NYSEArca: BSCE)
  • BulletShares USD Corporate Bond 2015 Index (NYSEArca: BSCF)
  • BulletShares USD Corporate Bond 2016 Index (NYSEArca: BSCG)
  • BulletShares USD Corporate Bond 2017 Index (NYSEArca: BSCH)
  • BulletShares USD Corporate Bond 2018 Index
  • BulletShares USD Corporate Bond 2019 Index
  • BulletShares USD Corporate Bond 2020 Index

The Bulletshares Indices contain approximately 1,400 of the most liquid corporate fixed income securities available to US investors. We filtered a total of 10.7 million trades and, after cross referencing the traded securities against the BulletShares Indices, created a database of 123,000 individual trades representing 1,400 securities and $45 billion in par value of securities. For the purposes of the white paper, we defined retail trades as transactions of less than $100,000 par value and institutional trades as transactions of greater than or equal to $100,000 par value.

After compiling the data, we looked for matching retail and institutional trades in the same securities on the same day, meaning there was both a retail transaction and institutional transaction for a given security on either the buy or sell side. The size of the retail markup for securities with matching retail and institutional trades was determined by subtracting the retail volume-weighted average price (“VWAP”) from the institutional VWAP and dividing this spread by the institutional VWAP. The resulting data set was further filtered by eliminating all trades outside of the middle 80% of the cumulative distribution of retail markups.

The table below summarizes the data set compiled through the process outlined above, indicating that, on average, retail investors pay 37 basis points more and receive 28 basis points less, respectively, when buying and selling the same individual corporate bonds as institutional investors.

Middle 80% of Trades with Respect to Markup



Average Institutional Transaction (Par)



Average Retail Transaction (Par)



Average Retail Markup/Markdown (Basis Points)



Standard Deviation of Markup/Markdown (Basis Points)



Number of Data Points



Total Trades



Factors that Influence the Retail Markup

The data suggest that while retail investors generally pay a sizable markup in individual corporate bond transactions regardless of the bonds traded, the size of the retail markup for any given bond on any given trading day correlates directly with (1) the effective duration of the bond, (2) the option-adjusted spread of the bond (which is a measure of the incremental return provided by the bond relative to a risk-free investment with a comparable term) and (3) the total par value of the bond traded on that day.

While it is not surprising that bonds with more duration and a larger option-adjusted spread afford bond dealers a greater opportunity to generate profits from trades with retail investors, the finding that more trading volume for a given bond is associated with a higher retail markup may strike some observers as counterintuitive. Most likely, this finding reflects the limited access retail investors have to the bond market: the bonds available for retail investors to purchase tend to be limited to the more heavily traded bonds.

Implications of the Retail Markup for Retail Investors

The size of the retail markup incurred by retail investors to trade individual corporate bonds suggests that retail investors may be better served accessing the bond market through packaged products (such as mutual funds and ETFs), which benefit from institutional execution, rather than through individual bonds.

Over the course of 2010, the institutional round-trip bid-ask spread for individual corporate bonds generally ranged from 10 to 40 basis points (0.10% to 0.40%) while the retail round-trip bid-ask spread for the same bonds ranged from 90 to 160 basis points (0.90% to 1.60%). In an era characterized by historically low bond yields, this institutional cost advantage represents a significant portion of the total return offered by bonds and should be considered when evaluating the management fees charged by bond mutual funds and ETFs.

While some individual bond investors have eschewed bond mutual funds and ETFs in the past because they lack defined maturity dates like individual bonds, several mutual fund and ETF sponsors have launched maturity-targeted bond funds that concentrate investments in a particular year of maturity and return investment capital to investors on a predetermined future date. Such products offer investors the opportunity to access institutional-caliber trade execution without giving up the benefits of individual bonds.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.