The brokerage industry was thrown into a tizzy when Charles Schwab, E*TRADE, Fidelity, Interactive Brokers, and TD Ameritrade recently cut online stock
trading commissions to zero. As this played out, executives at many full-service brokerages hid under their desks, as their firms often charge
clients 2% or more to execute corporate bond trades and municipal bond trades. These commissions eat away at investor returns and, for a bond yielding
3%, take away two-thirds of an investor's year-one interest income.
This blog post examines these two-point bond markups and the savings investors can achieve by buying bonds online rather than paying a financial advisor commission. I also discuss how subscribing to BondSavvy and using our recommendations to buy bonds online provides investors with a greater level of bond investing expertise, higher potential returns, and significantly lower investment fees.
A $48,040 Commission on One Bond Trade
Many investors believe that, to obtain the best bond price available, they must buy bonds in large sizes. This simply is not true, and we have the data to prove it. Figure 1 shows how an investor buying 10 bonds (or $10,000 in face value) achieved a better price than one purchasing 2,000 bonds (or $2,000,000 in face value). The investor achieved a better price by executing his trade through an online brokerage, which charges a far smaller markup than traditional commission-based financial advisors. In this example, we will show how the 2,000-bond investor paid an eye-popping $48,040 commission for the trade. Here's how this works:
In Figure 1, we show a series of trades in the Kroger 3.875% 10/15/46 bond (CUSIP 501044DF5) over a several-hour period during October 21 and 22, 2019. Corporate bond trades are reported to "TRACE," a pricing database managed by FINRA, an entity that regulates broker-dealers and is overseen by the U.S. Securities and Exchange Commission. TRACE enables investors to compare quoted corporate bond prices to those of recently executed trades. Investors can also review TRACE data to understand the historical pricing range particular bonds have traded. For each row of the table, TRACE indicates the price of the trade (expressed as a percentage of the bond's $1,000 face value), the number of bonds traded ("Quantity"), the yield to maturity ("YTM"), time of the trade, and the trade leg.
Figure 1: TRACE-Reported Trades for Kroger 3.875% 10/15/46 Bonds - CUSIP 501044DF5
In Figure 1, we have boxed series of trades in orange and green to illustrate the difference between buying bonds through an online brokerage vs. a full-service brokerage, which employs thousands of financial advisors and charges materially higher bond trading commissions.
Buying Bonds Online: Green Box in Figure 1
Online brokerage customers are the beneficiaries of a competitive market with over 100 dealers providing live bid and offer corporate bond quotes. I covered this in detail during my 2018 presentation to U.S. Securities and Exchange Commission. When online brokerages such as Fidelity and E*TRADE execute a trade for a customer, they typically don't already own the bonds, as this would require online brokerages to hold thousands of bonds on their books, an expensive and risky proposition. Instead, market-making dealers, including Bank of America, Morgan Stanley, Sierra Pacific Securities, and others post live bid-offer quotes that online brokerages show their customers. When an online brokerage customer clicks "Submit" to complete a trade, two "trade legs" occur: a "Customer Buy" leg (Step 3) and a "Dealer to Dealer" leg (Step 4) as illustrated in Figure 2:
Figure 2: Illustration of Self-Directed Investor Buying Bonds Online
* Since bonds are quoted as a percentage of their $1,000 face value, a 0.1-point markup is equivalent to $1.00.
In this example, the online brokerage customer saw a price of 94.631 when he was considering purchasing the Kroger '46 bonds. When he submitted his order, his brokerage added a 0.1-point markup to the bond. In dollar terms, a bond quoted at 94.631 is 94.631% of the bond's $1,000 face value, or $946.31. When the online brokerage adds the 0.1-point markup, the customer pays $947.31 for the bond, equivalent to a $1-per-bond markup. In the trade shown in Figure 1 above, the customer purchased 10 Kroger bonds. With the $1-per-bond markup, he incurred a $10 commission to execute the trade.
Online Brokerage Fee Schedules
While bond trading commissions vary slightly across online brokerages, they are generally within the same ballpark, with the exception of Vanguard, which has fees that are double its competitors for accounts up to $500,000. All of the brokerages shown below cap corporate bond trading commissions at $250 per trade.
Figure 3: Comparison of Online Corporate Bond Trading Commissions
Buying Bonds Through a Full-Service Brokerage: Orange Box in Figure 1
The above $10 bond commission is a far cry from financial advisor commissions paid to execute bond trades through a full-service brokerage. Investors who are clients of full-service brokerages are generally charged one of two ways: 1) as a percentage of assets the brokerage firm manages (a "fee-based account") or 2) through commissions generated when the brokerage executes trades on a client's behalf (a "commission-based account"). While the trend has been favoring investors migrating to fee-based accounts, as we will show below, the $48,040 commission paid for the 2,000-bond Kroger '46 investment is a fraction of what the investor would have paid to invest $2,000,000 in a fee-based brokerage account between now and the bond's 2046 maturity date.
Figure 4 shows how investing through a commission-based financial advisor increases investors' commissions relative to investing in bonds online.
Figure 4: Illustration of Investor Buying Corporate Bonds Through a Full-Service Brokerage
* Since bonds are quoted as a percentage of their $1,000 face value, a 2.402-point markup is equivalent to $24.02 per bond.
In the case of the Kroger '46 bond, this investor purchased 2,000 bonds at a price of 96.43, paying a commission of $48,040 as a result of the 2.4-point markup on the bond. Had this same investor bought bonds online, he would have saved $47,790, as, per Figure 3, online corporate bond trading commissions are capped at $250 per trade by the leading online brokerages.
This is a big price to pay, especially when investors opt to sell bonds prior to maturity to increase the total return of their bond investment.
Why We Picked a 2,000-bond trade
Ninety-nine percent of the readers of this post likely do not transact in $2 million lot sizes. As an entrepreneur for the last 2 1/2 years, I sure don't. The reason this example is so important is that, investors often assume that, the more money you have to invest, the better "deal" you are going to get. In this case, an everyday investor buying 10 Kroger bonds achieved a price significantly better than a larger investor because he invested in bonds online and paid a fraction of the financial advisor commission charged by a full-service brokerage.
It Could Have Been Worse
I believe it's hard to justify a $48,040 commission for one bond trade, especially in light of the many other advantages provided to online bond investors. That said, the 2,000-bond investor could have fared much, much worse.
Suppose, instead of paying the $48,040 commission and buying 2,000 Kroger '46 bonds, the investor placed the nearly $2 million with a fee-based financial advisor who charged 1% per year. How did that turn out relative to the other scenarios?
The 1% fee charged by fee-based financial advisors has been sold as 'not a big deal' to many. What's 1% among friends anyway? The problem is that, over an extended period of time, these fees are consequential, as shown in Figure 5.
As discussed above, an investor purchasing 2,000 Kroger '46 bonds on October 21, 2019 paid 96.43 or $964.30 per bond, for a total investment of $1,928,600, which included a $48,040 markup. Had the investor opted to make this investment through an online brokerage, his total markup would have been $250. Assuming both investors held these bonds to the October 15, 2046 maturity date, these markups would be the only trading-related fees charged to the investor.
On the other hand, had the investor placed the $1,928,600 with a fee-based financial advisor who charged 1% per year, the amount paid in fees between now the October 2046 maturity would be a staggering $700,916, an average of $25,960 per year over 27 years. The coupon on the bond is 3.75%, so our 2,000-bond investor would receive $75,000 in annual interest income, or approximately $2,025,000 between now and the maturity date of the bond. As shown below, the fee-based advisor will reap $700,916 in fees over the next 27 years and will keep 34.61% of the investor's total interest income, assuming the client invested in the same Kroger '46 bond. This isn't as bad as when advisors placing clients into the oddly popular Vanguard Total Bond Market Index Fund between 2015-2018 earned more than their clients, but it's a close second.
Figure 5: Costs of Investing $1.9 Million in Kroger Bonds over 27 Years
It’s How You Invest, Not How Much
With individual corporate bonds, it's not about how much you have to invest but rather how you invest. The first step in deciding how you invest is selecting the setup of your brokerage account among three choices: 1) a self-directed online brokerage account, 2) a commission-based financial advisor, or 3) a fee-based financial advisor. The second step is to decide which bonds to add to your portfolio. I recommend investors open a self-directed brokerage account at either Fidelity or E*TRADE and then subscribe to BondSavvy to determine which bonds to buy.
Which type of brokerage account to use
Online brokerages such as Fidelity and E*TRADE have invested heavily in their trading platforms to make them efficient, transparent, and investor friendly. Customers of these online brokerages can view a bond's depth of book to see the number and size of bid/offer quotes and enjoy trading commissions that are a fraction of financial advisor commissions. They can also transact in trade sizes of 2 to 100+ bonds and achieve similar, and often times better, prices than larger investors.
Please view my July 2018 presentation to the US Securities and Exchange Commission to better understand the quality of corporate bond prices available to individual investors.
Buying corporate bonds online is easy. BondSavvy subscribers enter the CUSIPs of our recommended bond into their online broker, and the trades are executed in a matter of seconds.
As discussed above, there is a huge cost associated with using a full-service brokerage, be it through a commission-based financial advisor or a fee-based financial advisor. On top of this, the financial advisors servicing your account likely have zero knowledge about investing in bonds. Investors are, in many cases, paying a lot of money for someone who is not “BondSavvy.”
A new vision for bond investing advice
I believe the current financial advice model is flawed and in need of a major overhaul. Today, investors collectively spend billions on financial advisors; however, advisors typically lack any expertise investing in bonds. Investors need to ask themselves what they are getting in return for the fees they are paying, and it needs to be more than an invitation to a Member-Guest golf tournament at a prestigious country club.
For each asset class, investors should demand the highest level of expertise available. For individual investors investing in corporate bonds, BondSavvy provides the industry’s highest level of expertise, as we know how to evaluate corporate bond investments from the perspective of individual investors better than anyone.
We are best in class for the following reasons:
- Analysis superior to bond ratings: Our investment recommendations are superior to Moody’s and S&P bond ratings, as we evaluate
all of the relevant factors that impact a bond investment’s rationale, including: the price of the bond, its yield relative to comparable bonds,
its interest rate risk, the company’s financials relative to similar bond issuers, and which bond out of all of an issuer’s bonds presents the
most compelling value. Corporate bond ratings only measure credit risk, and they don’t do that particularly well as I discussed in this blog post. In addition, credit ratings do not speak to the value
of an investment and are made at an issuer level – not the CUSIP level, which is what BondSavvy provides.
- 100% focus on individual corporate bonds: I founded BondSavvy because corporate bonds are a $9 trillion market that more investors need to understand and incorporate into their portfolios. Individual corporate bonds is where we devote all of our time and how we identify investments that have outperformed the market. Traditional financial advisors spend their time gathering assets and managing their accounts. Our 100% focus on individual corporate bonds provides a significant advantage over financial advisors for those looking to invest in corporate bonds.
- Intimate knowledge of online brokerages: I was previously Head of Tradeweb Direct and a senior executive of BondDesk Group, companies that build systems for individual investors and financial advisors to buy and sell bonds online. Fidelity, Charles Schwab, E*TRADE, and Interactive Brokers were all clients of these companies, and I know how their systems work for the benefit of investors. These brokerages provide significant information around each bond available, and, as BondSavvy's chief investment analyst, I know how to use the information provided to narrow down investments to those that can outperform the market.
- Higher potential returns: As shown above, financial advisor commissions eat into a significant portion of an investor’s return, especially if it is a fee-based financial advisor, which extracted over one-third of an investor’s interest income in the above example. You earned the money you are investing. BondSavvy empowers investors to grow their money at a faster rate and with significantly lower fees than traditional financial advisors.