Corporate Bond Investing Myth #1 -- You Get Ripped Off if You Sell

Corporate Bond Investing Myth #1 -- You Get Ripped Off if You Sell
The scoop: Contrary to what everyone has told you, individual investors can sell corporate bonds at a fair price. 

Across different parts of the BondSavvy site, including this page, we have shown how owning a select group of individual corporate bonds has outperformed bond funds and ETFs.  In addition to performance, there are other advantages individual bonds have when compared to funds and ETFs such as a return of your principal at maturity, payment of a fixed coupon, and greater transparency over what you own.

So why would people continue investing in bond funds and not capitalize on the advantages of owning the individual bond?

One reason is the experts have been telling us that, once you buy a corporate bond, it is extremely difficult to sell it.  And, if you are lucky enough to sell, you'll get your head handed to you in the process.

Corporate Bond Investing Myth #1: You Get Ripped Off if You Sell

This blog post provides concrete examples showing why this concept is, in fact, a myth. 

I have sold corporate bonds on a number of occasions, and it is not the harrowing experience many say it is.  The substantial majority of retail-sized trades ($100,000 face value and under) are executed on electronic trading platforms.  As a result, investors benefit from a marketplace where over 100 dealers are providing bid and offer quotes on different bonds.  All of these quotes are consolidated by the various trading systems and shown out to you through your brokerage.  Often times, upwards of seven different dealers can be quoting bids and offers on the same bond.  This strong 'depth of book' is a benefit to investors since many dealers compete for your order, which has helped reduce bid-offer spreads on corporate bonds.  

To illustrate, I conducted a corporate bond search August 24 on a leading online broker.  The search included both investment-grade and high-yield corporate bonds and contained the following group of bonds:
  1. -- 2,326 investment-grade corporate bonds with yields between 3.55% and 6.48%
    -- 665 high-yield corporate bonds with yields between 4.85% and 25.79%  
To dispel the myth that selling a corporate bond is a fool's errand, the below two charts show the distribution of bid-offer spreads that were quoted for the different bonds.  Note that a dealer's bid quote represents the price at which you could sell the bond, and the offer quote is the price at which you can buy the bond.  Having a two-sided market, or quotes on both the bid and offer sides, can help investors evaluate their ability to sell a bond at a fair price once they buy it.  Here are the key takeaways from the charts:
  • -- 90% of investment-grade and 77% of high-yield bonds had a two-sided market
    -- 50% and 43% of high-yield and investment-grade corporate bonds had bid-offer spreads of one point or less*, respectively
    -- The high proportion of bonds with a two-sided market and with bid-offer spreads of one point or less should give investors comfort that they can sell corporate bonds at a fair price 

One thing to keep in mind is that the investment-grade corporate bonds had an average maturity of 2038 while the high-yield corporate bonds had an average maturity of 2028.  This is one of the reasons why, for the investment-grade corporate bonds, a higher proportion have bid-offer spreads greater than one point.  Since investment-grade bonds are typically 'longer duration' -- meaning they have more years to maturity than high-yield bonds -- it takes a bigger dollar-value spread to have an impact on the bond's yield to maturity compared to a shorter duration bond. For example a bond that pays 5%, matures in 30 years, and has a bid/offer quote of 101/103 (a 2-point bid-offer spread) would have corresponding yields to maturity of 4.94%/4.81%, which is still reasonably narrow.  Section 4 in the Crash Course on Corporate Bond Investing  provides a full discussion on this point. 

To see these quotes in practice, the following table shows the 'depth of book' for a Hewlett Packard corporate bond**, which pays a 6.000% coupon and matures September 15, 2041:



In this example, there are five dealers providing a bid-side quote and seven with an offer-side quote -- a competitive market on both sides.  Here, the 'top-of-book' quote is 106.705/107.135, which implies a 0.43 point bid-ask spread in dollar terms or 0.03% (or 3 basis points) in yield terms.  

With five dealers quoting on the bid side in a fairly tight range, we strongly believe investors can sell this bond -- and thousands of others -- at a fair price.

Can't I still do better with a bond fund?
Not really, and for a number of reasons.  First, bond funds still have to buy and sell bonds and, for retail-sized trades, the quotes they receive are similar to, and at times worse, than what individual investors receive.  In addition, some funds, such as the BlackRock High Yield Bond Fund (BHYAX) charge sales loads, which in BHYAX's case can be as high as 4%, the equivalent of a 4-point bid-offer spread.  

CONCLUSION:
Individual investors can get a fair shake when selling corporate bonds as shown in our above examples.  It's a competitive marketplace with the vast majority of corporate bonds having a two-sided market with spreads that have grown tighter over time.  These bid-offer spreads compare favorably to the sales loads investors pay to invest in certain mutual funds.

With Corporate Bond Investing Myth #1 now debunked, and with individual bonds' higher potential returns vs. funds, repayment of principal, and payment of a fixed coupon, the case for investing in individual corporate bonds continues to strengthen.


Footnotes
* Bonds are quoted as a percentage of their $1,000 face value, so a quote of 99 means 99% of the $1,000 face value, or $990. A bid-offer quote of 99/100 would be a one-point spread, or $10 between the bid and offer quotes. Therefore, if you bought 10 bonds at par (or 100), paying $10,000, you could sell these same bonds for $9,900, losing $100 as a result of the 1-point bid-offer spread.
** Quantities are presented in numbers of bonds, each with a $1,000 face value.  The minimum quantity represents the minimum order size to execute a trade at the corresponding quote.

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