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Secondary markets for retail…

Explore Bonds wrote an excellent post titled: Where to Buy TIPS On the Secondary Market… this is very useful and practical advice about the mechanics of retail bond purchases… kudos to the blog author for aggregating the information. There is also much to reflect on in this post as it relates to market structure for fixed income securities for retail investors… especially the lack of pre-trade transparency… think about how much effort every investor must make to scout around for prices on the same bond from a group of dealers… I wrote on this issue in comments to the SEC last year in relation to Reg ATS particularly the need to square up fixed income trading rules with equity market trading… the need to create formal linkages between trading venues and pre-trade transparency … the equity and fixed income markets are miles apart now and of course it’s retail investors who suffer… I’ve shared my concerns with Senate Banking Committee staff  and encouraged them to ask the SEC to broaden their study of market structure to include fixed income trading in dark pools and ATS… I’ll revisit this topic… From Explore Bonds: ~~~ “You decided that this is a good time to buy some TIPS on the secondary market and you picked out which one to buy. Now where do you buy it? You need a brokerage account. There’s no way around it. TreasuryDirect does not sell secondary market TIPS. If the brokerage firm you use is a small discount broker that does not handle bond orders, you need to find a larger brokerage firm that does. Fidelity, Schwab, E*Trade, TD Ameritrade, all do. If you use Vanguard or T. Rowe Price, you need their brokerage account; a regular mutual fund account will not work. If you have accounts with several brokers or if you are buying a large amount, you may be interested in finding out which broker is most cost effective for your order. Unlike buying stocks, ETFs or mutual funds, commission is only a small part in the cost of buying bonds on the secondary market. The largest cost is the markup included in the quoted price. (see Finra 2440) The markup is the price difference between what institutions pay for wholesale trades and what your broker charges you for retail purchase. The markup comes from your broker and/or the dealer from which your broker gets the bonds. A broker that charges you no commission but adds a big markup to the price can be more expensive than a broker that charges you a commission on a smaller markup. Your broker discloses the commission but it never discloses the markup. This table lists the commission from a few discount brokers for purchasing TIPS on the secondary market.

Online Inventory Online Broker Assisted
Fidelity Proprietary included in markup $20 + markup
Schwab Proprietary included in markup $25 + markup
E*Trade BondDesk included in markup $20 + markup
Vanguard (VBS) BondDesk $0-$75 + markup $20-$125 + markup
Zions Direct BondDesk $11 + markup $36 + markup
WellsTrade BondDesk no online trading included in markup

Many brokers use bond price quotes from BondDesk Group. BondDesk is a platform on which some bond dealers post their prices for retail investors. However, two brokers both using BondDesk don’t necessarily show the same price for the same bond. Your broker can add a markup to the BondDesk price before showing the price to you. Fidelity and Schwab don’t use BondDesk. Here are the prices and total bottom line costs I got when I priced one particular bond online one day when the market was open. I tried to make them comparable apples-to-apples. I opened multiple browser windows and requested the quote within a few seconds of each other.

Total Cost
Price 1 bond 10 bonds 100 bonds
Fidelity 97.020 $1,069 $10,694 $106,936
Vanguard 97.293 $972 to $1,047 $9,729 to $10,479 $97,293 to $104,793
Zions Direct 97.466 $1,085 (+$16) $10,767 (+$73) $107,576 (+$640)
E*Trade 97.830 $1,078 (+$9) $10,782 (+$88) $107,821 (+$885)

The numbers in parenthesis are the additional money I would’ve had to pay if I purchased from a higher cost broker. Fidelity happened to have the lowest cost on that day. That doesn’t have to be true all the time.Remember these were only for one particular bond on one particular morning. Much like when you buy a big screen TV, this week Sears may sell a Sharp 37″ cheaper but Best Buy may sell a Toshiba 52″ cheaper. And next week it could be just the opposite. You can see the effect of commission versus markup from this exercise. Vanguard charges commission on top of prices from BondDesk whereas E*Trade does not. But the price from E*Trade was higher. If I bought one bond, Vanguard was more expensive. If I bought 10 bonds or 100 bonds, Vanguard became much cheaper than E*Trade. The lack of pricing transparency on the secondary market is really unfortunate. It makes it difficult for you to comparison shop. Most of the online quotes are take-it-or-leave-it. You can’t enter a Good-Til-Cancelled limit order and wait for the price to meet what you wanted. Sometimes the initial online quotes are not even executable. One time I saw a quote from Vanguard but as soon as I try to place an order to buy, the price went up. But when I tried to place an order to sell, the price went down. Fidelity lets you enter a limit order within a narrow range. Even those orders are fill-or-kill which means if they want to take your price they will do it, otherwise they just throw your order away. If you want to change your limit price you will have to enter a new order. If you want to get a better price than the online quote, it doesn’t hurt to try a limit order below the ask price and slightly above the mid-point between bid and ask prices. Sometimes it takes a few tries. A member of the Bogleheads forum grok87 suggested entering a limit order at 1/3 of the bid-ask spread Fidelity asks for. People seem to have good success rate with that.

buy limit price = ask – (ask – bid) / 3

Trading bonds online is still relatively new to brokerage firms. Most of them also offer rep-assisted trades by phone at a higher commission. Is it worth it to place the order by phone? The answer is probably yes because the phone reps may have access to different systems that provide a better price than what you can get from the online system. This becomes important especially if you are buying a large amount. The price difference can negate many times the ~$25 extra commission for phone orders. When you talk to the rep by phone, it’ll be helpful if you know the CUSIP number for the bond you are interested in. CUSIP stands for Committee on Uniform Security Identification Procedures. The 9-character alphanumeric CUSIP number uniquely identifies a bond like a ticker symbol does for a stock. I have the list of CUSIP numbers for all TIPS bonds on the market today here:

Spreadsheet: TIPS CUSIP List

Give the CUSIP number to the phone rep and ask for a quote. Compare it with the online quotes from the same broker or even a different broker. Challenge the phone rep to give you a better price than the online quote. Because of the opaqueness of the secondary bond market, I avoid buying on the secondary market unless there’s a compelling reason.

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