Bonds Primer: Focus on Transaction Costs

Even if you have the tens of thousands of dollars it takes to amply diversify a bond portfolio, it doesn't necessarily make sense for you to buy individual bonds instead of bond fund shares. The reason is transaction costs.

When you buy bonds from a broker, the broker will, instead of charging a commission, mark up the price of the bonds by an undisclosed and only very loosely regulated amount, lowering your yield. If you don't know how much other investors have been paying for the same security -- in other words, if you don't know what yields they've been getting -- you run the risk of getting a lot less. As we discussed in an earlier piece, it isn't easy to find out how much others have been paying.

Plus, in a world where $25,000 is considered a small block, the fewer bonds you buy, the more your broker will mark up the lot. (Note that you're already impinging on his time by demanding a lower-margin product than stocks.) That higher markup lowers your yield even more.

The Bond Market Association says transaction costs range from 0.5% to 2.5% of the face value of the bond ($5 to $25 per $1,000 of face value) for municipals, and from 1% to 3.5% ($10 to $35) for corporate bonds, meaning that the broker marks up each bond's price by that amount.

Arizona State University finance professor Michael Joehnk says those estimates are "pretty much on the low side." He says 5% ($50 per $1,000 of face value) markups are customary on lots as large as $25,000, and 7.5% ($75) markups aren't unusual on thinly traded munis.

To see how a markup affects your yield, let's look at an example. Say you're going to buy some 7% coupon bonds maturing in 2008 (the type doesn't matter). The dealer who's selling them to you got them for 93.19 (bonds are quoted in cents on the dollar), or $931.90 for a bond with a face value of $1,000, to yield 8%. You pay a 5%, or $50, markup. Your price is now 98.19, so your yield drops to 7.26%.

Transaction Costs The effect of a 5% ($50 per $1,000 bond) markup on a 10-year bond's yield. Coupon Price Yield Before 7% 93.19 8% After 7% 98.19 7.26%

Should you need to sell your bonds before they mature, your broker will mark them down for his profit by a similar margin, acquiring them from you at a higher yield.

Still scorning bond funds? Yes, they charge expenses. But you're getting the bonds at institutional prices, where the markup may be $5 or less per bond.

The size of your markup depends on how many bonds you buy. There are no hard-and-fast rules, though.

Brokerage firms don't want to talk about it. Calls to a few of them on this topic went unreturned. But Joehnk had a few answers. Talking to retail trading desks, he says, he learned about "certain cutoffs."

"Twenty-five thousand [dollars of face value] seemed to be a magical number," he said. "So did $50,000. But the really important one was $100,000."

What it means, he says, is that if you're buying $25,000 worth of bonds, expect a markup in the 4% to 5% range. But if you're buying $100,000 or more of a single issue, you can probably negotiate a much smaller markup, as low as 0.5%. "In that category," Joehnk says, "you're no longer a nuisance."

Buying New Issues

There are a couple of ways to avoid all these vagaries. The first is by sticking to the new-issue market (for U.S. government bonds, municipals and corporates; new Treasury issues, remember, are available through Treasury Direct).

Everyone who buys a new issue pays the same price -- the offering price, less the fully disclosed underwriter's profit -- regardless of how many bonds they buy. If you buy only new issues and hold them to maturity, you can largely avoid sacrificing yield to your broker.

A downside of the new-issue market is that if your brokerage firm isn't participating in the underwriting, you generally can't get the bonds on those terms. In the corporate market, you'll be lucky to get in on new issues at all, Joehnk says.

"You can't go by the tombstones in the Wall Street Journal," he says, referring to notices of offerings placed in the newspaper. "Many times they've already been sold by the time those things appear." Dealers "tend to call their preferred customers" when they've got a hot new issue to sell. Unless you've got a bond portfolio of at least half a million dollars, don't wait by the phone.

Buying on the Exchanges

The other way to demystify bond-pricing is to buy bonds that trade on exchanges. The New York Stock Exchange lists about 2,000 corporate issues representing $2.6 billion of face value, and the American Stock Exchange lists 85 issues representing $360 million of face value. Prices of bonds that traded in the previous session are listed in The Wall Street Journal.

But the exchange-traded universe is a fraction of the $2 trillion corporate bond market. And unless you're buying in large volume, the commission you'll pay on the trade will also eat deeply into your yield. Still, Joehnk says, "it's the one case where the price you see is the price you get."

The Schwab Center for Investment Research is working on a study to get at exactly how much it takes to build a diversified, economical bond portfolio. A vice president at the center, Mark Riepe, says he's not aware of any earlier conclusions on the subject. "You don't find a lot of people talking about this in concrete, numerical terms," he says. "They'll just say, You need a lot."

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