7 Ways to Improve Transparency and Accountability in the Bond Market

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bond marketIn recent years, individual investors have been plowing money into bonds at impressive rates. Some reasons for this might include a now stronger desire for a return of capital rather than a return on capital, the desperate search for yield in an environment that is challenging for savers, and the goal of having less volatility in one’s portfolio. For those investors who have ventured into the world of individual bonds, you are perhaps aware of the opaque nature of the system in which you are building your income portfolio. I shared some of my experiences regarding individual bond purchases in the article “Corporate Bond Market Shenanigans You Should Know About.

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Despite many frustrating experiences when trading in the individual corporate bond market, for me, the benefits of owning individual bonds still outweigh the negative effects of the issues I encounter. In fact, especially in the investment-grade corporate bond space, I much prefer to own individual bonds over bond funds. Even though I am not abandoning individual bonds due to the various challenges I’ve encountered, I do have a wish list of changes I would like to see in that marketplace. I am aware that my wish list of changes to the individual bond market is not likely to be implemented any time soon. But I would still like to present a few ideas with the hope that someone who has the ability to effect change reads this article and finds even just one idea to be constructive.

Without further ado, here are a few ideas for improving transparency and accountability in the individual bond market:

  1. Require markups on bonds to be disclosed. If a mutual fund charges a sales load, investors can easily find out this information before making a purchase by looking on the fund’s webpage. That is not the case in the world of individual bonds. I can envision the disclosure being presented on sales materials advisors send to clients, displayed with the price of a bond after investors run a screen on a brokerage platform, or during the purchase process (whether online, over the phone, or in person).


  1. It would also be helpful if investors could be aware of the best currently-available bid or offer in the market. The Financial Industry Regulatory Authority (FINRA) is kind enough to provide time and sales data for individual bond trades reported to its Trade Reporting and Compliance Engine (TRACE). While this information helps investors see the most recent trades on a particular bond, it does not help investors determine the prices of the current best bids and offers. For example, let’s say your broker shows an offer of 98 for a bond you are interested in purchasing. You notice the last trade on the bond, which took place just a few minutes ago, was at 99. This gives you the impression you are receiving a good price. But little did you know that the investor who purchased at 99 actually purchased a bond marked up from 97, and that the current best offer in the market is at 97, not 98. If FINRA had the means to present the best currently available bid or offer in the market (perhaps pull it from Bloomberg), that would go a long way in improving transparency in the individual bond market.


  1. When retail investors submit orders through a broker, the order is not always sent directly to the marketplace for immediate execution. It is possible that an order is first “shopped.” I have had orders shopped that were eventually filled at more attractive prices than the limit prices I entered. But if you do not receive a fill because an order was shopped and the market moved against you (resulting in your order eventually being cancelled by your broker), you will likely not be happy. This is especially true if you were content to lift the offer at the time you entered your order. It would be nice for retail investors to have the ability to designate, prior to an order’s submission, whether or not they want the order to be eligible to be shopped.


  1. Direct market access would certainly be more beneficial for retail investors. Perhaps brokers could provide the option of having the order routed through traditional means or sent directly to the marketplace. If necessary, a different commission schedule could even be created for direct market access orders. At this time, the only retail brokerage bond platform I know of that allows direct market access is tradeMONSTER’s. The tradeMONSTER platform includes streaming quotes, which also may be a first for a retail brokerage platform. Real-time quotes is certainly something I would love to see on all retail brokerage platforms.


  1. In the aforementioned article, I shared some thoughts on so-called “stale” liquidity. This refers to bids or offers that show up on a brokerage platform as if they represent legitimate liquidity in the market. But, in fact, they do not. In my opinion, if a dealer leaves an offer available for all participants in the market to see (the order is represented in the market), that dealer should be required to honor an order that attempts to hit the dealer’s bid or lift the dealer’s offer. Laziness or making a mistake (forgetting to remove the liquidity or change the price) is no excuse for allowing a dealer to reject an order. Mistakes happen. Bond dealers need to accept the consequences of such mistakes. I can virtually guarantee you that if I make a mistake on my order entry, I do not get a do-over. It would be nice if dealers were held to the same standards.


  1. I would like to expand on the issue of “mistakes happen”: On one occasion I even had an order filled by my broker only to have it reversed several minutes later on account of my “not being due a fill.” This occurred despite the fact that an actual person made the decision to fill the order at the price it was filled. In other words, a human being looked at my order, made the conscious decision to fill the order, and then, after realizing it was a mistake, also had the power to reverse the order. Again, I can virtually guarantee you that if I made a mistake on an order entry, I would not get a do-over.


  1. Last, but not least, it would be really nice for all retail brokers to allow “good-til-cancelled” orders on individual bonds. In today’s technologically advanced world, retail brokers shouldn’t need to cancel individual bond orders after just several minutes of remaining in an open status. Moreover, without the ability to enter “good-til-cancelled” orders, investors are likely to miss prices at which they were willing to purchase a bond. After all, most people do not have the luxury or the desire to sit around all day waiting for a bond to hit their price.

To summarize, I long for the day when markups are disclosed, dealers have to live with the consequences of their mistakes, and “good-til-cancelled” orders become a reality. Furthermore, is it too much to ask that retail investors, regardless of their broker, are able to see the currently best available-in-the-market bids and offers on an individual bond as well as have their orders sent directly to the market for immediate execution? I am not saying any of these changes would be easy to implement. I am sure those in favor of the status quo would come up with impressive-sounding counterarguments to each of these ideas. Nevertheless, if you want to improve transparency and accountability in the world of individual bonds, these are some ideas that should be carefully considered.

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  1. Once you get passed the 100 or so top issues, you are in the wild west of bond investing. The bond market is and will continue to be opaque because there are many issues where liquidity is available but you must have the tools and intellect to discover price. I absolutely agree that owning underlying credits is better, but without the capacity to analyze and execute, it is best left to the pros. Typical muni fund managers charge 25bps/yr and they make there fee many times over by taking advantage of curve transactions. To pay a 2% or greater markup on any bond vs a manager’s fee is simply not smart investing. What you are looking for, and typical of a novice investor, is the same liquidity premium paid for by most of the major managers (they typically buy issues with no greater than a 3bp market spread). If you understand the credit (and that takes time), you can easily determine the market. Once you determine the value, you, even the small investor, can drive the market. It takes patience, and market expertise. If you have both your returns will outpace the funds. Without them you are in for a wild ride.


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