Bond Trade Execution and Market StructureDecember 15th, 2011 by David Waring
1) Exchange Traded Market
Most stocks trade on a centralized exchange such as the New York Stock exchange. As there is one central place where all trades happen, there is a significant amount of price transparency. In other words everyone knows what the price of a stock is at all times, and at what price other buyers and sellers are being executed at.
2) Best Execution Rule
Stock Brokers are required by law to provide you the best price available to them on the market. In other words, your brokerage firm cannot sell you a stock that they already own at price that is worse that what they can obtain on the exchange.
3) Tight Market Prices
For most stocks, prices on the open market are very, very good. What do we mean by good? The spread (difference between the price at which you can buy and sell) is small. Usually, 1 to 2 pennies per share. The smaller the difference between the buy and sell price, the less flexibility there is in determining the price where you are executed.
Bonds Are Different
Instead of trading on a central exchange (like the NYSE for Stocks) most bonds instead trade through a network “dealers” who hold inventories of bonds. When trading most types bonds your bond broker does not go to an exchange like the New York Stock Exchange, they go directly to a dealer who specializes in trading the type of bond you are trying to buy.
This means that there is much less standardization and price transparency in the bond market than there is in the stock market. Because of this the price that one investor pays for a bond may be significantly different than the price another investor pays, when doing a trade in the same type of bond at the same time.
Our research has shown that investors often overpay by as much as 4% when buying a bond. While this may sound like a small number in the current environment, 4% may be more than you make in a whole year when holding a bond, so its a very large number.
This is why the broker you chose to work with is so important, as a large factor in determining the price you get will be their knowledge and access to the right dealers.
What Factors Ultimately Determine the Price You Pay for a Bond?
1) The Type of Bond
The more actively traded or “liquid” a bond is the more likely you are to get a good price on the bond. Some bonds, like treasuries, trade vary actively so the spread is low and the price transparency is high. Other bonds, like municipal bonds, do not trade very much at all after the initial issue, so the spread is high and the price transparency is low. For this reason you are more likely to get a bad price on a municipal bond than a treasury bond.
2) The Trade Size
Generally the larger the size of the trade for corporate bonds the better the price. This is not always the case for municipal bonds.
3) The True Market Price
This is the price that a professional bond trader or institution would get if they were trading a bond. In other words the best price available in the market. How close the individual investor can get to this depends on:
4) The Dealer Markup
The dealer who your broker buys the bond from on behalf of the investor can “mark up” the price of the bond. This means if the “true market price” is 100 to buy and 99 to sell (a spread of 1), then the dealer may “mark up” the spread he gives your broker to say 97 to sell and 102 to buy. A good bond broker will know when the price is being marked up unfairly and take your order elsewhere.
5) The broker Markup
Just as the dealer can mark up the price so can the broker.
This lesson is part of our Free Guide to the Basics of Investing in Municipal Bonds and our Free Guide to Investing in Corporate Bonds. Continue to the next municipal bond lesson here and the next corporate lesson here.