What You Don't Know About the Bond Market Can Hurt You

by: Larry Swedroe posted on: February 07, 2008 | about stocks: IEF / SHY / TLT

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In the classic fairy tale Snow White and the Seven Dwarfs, the evil Queen, Snow White’s jealous stepmother, arrives at Snow White’s cottage disguised as an old peddler woman. Despite being warned by the seven dwarfs to not open the door for anyone or accept any gifts, Snow White answers the door. The Queen uses the girl’s naiveté against her and lures Snow White into taking a bite from a poisoned apple. Falling into a sleeping death, Snow White can only be awakened by love’s first kiss.

The moral of the story is that children should be wary of old ladies who come knocking at their door tempting them with treats. It is more than likely that the old lady has a hidden agenda. The broker-dealer community knows that individual investors lack sufficient knowledge about the bond market, which makes exploiting them as easy as “taking candy from a baby.” Unfortunately for those investors, Prince Charming will not be riding in on a white horse to save them or their portfolio.

The Games Brokers Play—At Your Expense

Brokers exploit the naiveté of investors in several ways. The first is through markups (when an investor buys a bond) and markdowns (when an investor sells a bond). It is very unfortunate that the SEC does not require a broker-dealer to disclose the amount of markup or markdown charged. The result is that transactions costs in bond trades can be like icebergs, where the largest part (seven-eighths) is hidden beneath the surface. Because glacier ice is only slightly lighter than an equal amount of seawater, most of an iceberg remains below the waves. It is very dangerous for boats to travel in icy waters without equipment that can help them locate an iceberg.

When buying bonds, the danger is that because the only required disclosure is the transaction fee (which is not a commission, rather an administrative fee), most investors assume it is the only cost they will incur— typically a nominal amount such as $25, or even less. However, typically, this is just the tip of the iceberg. Markups and markdowns can be quite large since there is little in the way of regulations to prevent abuses. The following will likely shock most investors.

In a May 2002 ruling, SEC administrative law Judge Lillian A. McEwen dismissed fraud charges brought by the SEC and the MSRB against a Los Angeles broker. McEwen concluded: “Markups and markdowns on municipal securities ranging from 1.87 to 5.64 percent were not excessive and did not violate the securities fraud laws.”[^1]

There are other ways for brokers to transfer wealth from their clients to their own pockets. The first example relates to the maturity of the bonds brokers prefer to sell. Investors need to be aware that the size of the impact of a markup or markdown on the yield of a bond is negatively related to its remaining term to maturity. For example, a bond with a remaining maturity of just one year will see a return impact of one percent for each one point of markup or markdown. However, the impact on yield is reduced as the term to maturity lengthens because the markup will be “amortized” over a longer time. Consider the following example.

A bond with a remaining term of just one year is yielding 3 percent and trading at par (100). A markup of even 1 percent would be very hard to hide, as the yield to maturity would drop by more than 1 percent to 1.98 percent. On the other hand, if the bond had a remaining term of ten years, the yield to maturity would fall to about 2.85 percent—a drop in yield of just 0.15 percent. And if the bond had a remaining term of twenty-five years the yield to maturity would fall to about 2.93 percent—a drop in yield of just 0.07 percent. The longer the maturity, the less the impact on yield to maturity and the easier it is to hide the markup. Now imagine a broker wanting to take a markup of four points on the same bond. That would be very hard to do with a bond with just one year remaining to maturity because the yield to maturity would then be negative—the investor would pay 104 for a bond that in one year would return his $100 in principal and just $3 of interest. On the other hand, the impact on the yield to maturity of a bond with twenty-five years to maturity would be only about thirty-one basis points (0.31 percent) per annum.

It isn’t hard to guess which maturities brokers push when selling bonds to individual investors. Unfortunately, not only do investors end up paying large transaction fees, but they also end up taking far more price risk than would be typically prudent. As an example, I was recently asked by a CPA to review the bond holdings of his client, who was 86 years old. Not surprisingly, I found that there were many bonds with maturities of over twenty years. In addition, every one of those bonds had call dates within the next few years (a subject we will shortly address). Now there is probably no good reason for an 86-year-old to own bonds with maturities approaching thirty years, well beyond his life expectancy. In addition, the greatest risk to this investor was inflation, and longer bonds have the most inflation risk.

And as is typically the case, the investor had a long relationship with the broker who worked with a prestigious firm. Unfortunately, the trust he had in both the long relationship and the firm was misplaced.

Double Dipping

One of my favorite Seinfeld episodes is the one where George is caught double dipping his chip. One of the guests pointed out that George’s action was a hazard to the health of the other guests. Brokers also engage in double dipping—a practice that is hazardous to the wealth of investors. Let’s examine how the double dip works in the bond world.

Brokers exploit individual investors by selling premium bonds that have call dates that are much closer than the maturity date. The bonds sell at a premium as a result of their high coupons (the attraction) relative to current market rates. The higher than market coupon means that the issuer will likely call the bond at the first opportunity. Consider the following example.

A bond with a remaining term to maturity of twenty-five years is carrying a coupon of 6 percent. The current market rate for similar bonds is now 4 percent and the bond can be called at 101 in one year. Despite the relatively high coupon (2 percent above the current market rate) and the long remaining term to maturity, the bond should not be trading much above the call price of 101 because of the nearness of the call date and the high likelihood that the bond will be called by the issuer. Let’s assume the bond is trading at 103. Now the broker decides to add a markup of five points and sells the bond to the investor at 108. While the yield to maturity is about 5.6 percent, well above current market rates, the bond will almost certainly be called in one year. Assuming it is called at 101 the investor will have earned the coupon of 6 percent and lost seven points in price, producing a net loss of 1 percent. As you can see, the investor was actually sold a bond with a negative expected return! This is not as rare as you might think. But it gets worse. When the bond is called the broker will call the investor to advise him of the call. The investor now has to reinvest the cash and the broker gets to “double dip.”

A less extreme example would be if the call date were in three years instead of just one. In this case the price of the bond in the wholesale market would be around 106. With the same markup of five points the bond would be sold to the investor at 111. If the bond is called at 100 in three years, as is likely, then the investor would have earned a return of less than 3 percent (having earned the coupon of 6 percent but also having to amortize the premium of eleven points over just three years).

For a variety of reasons the prudent approach to buying bonds is to be sure that if the bond is callable that you have at least 80 percent call protection (e.g., if there are ten years remaining until maturity the earliest call date is at least eight years).

If you are concerned that you have been taken advantage of there is a solution. I recommend that you bring a list of your current holdings along with the original transactions slips (showing what is called the CUSIP number and the date of the trade) to an independent financial advisor. They can analyze your holdings to see if the types of abuses we have discussed have taken place (including uncovering the size of the markup/markdowns that were charged).

While it is likely that it is too late to do anything about prior abuses, there is no reason to allow them to continue once you are aware of the games brokers play at your expense. Preventing them will allow you to take that trip to Hawaii, instead of your paying for the broker’s trip.

[1]. Lynn Hume, “Judge Dismisses SEC Case Against Former Broker, Rules Markups Not Excessive,” Bond Buyer, May 1, 2002.

Disclaimer: Larry's opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management.