Why You Should Never Buy Another Physical Bond

By: ispeculatornew
Date posted: 06.29.2012 (5:00 am) | Write a Comment  (0 Comments)

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I know, I know, I wrote about how much bonds you should own in your portfolio so you are probably thinking that I’ve turned insane or something. I assure you I have not. But today, I was reading about the new Pimco Bond Total Return ETF fund (TRXT) and trying to think about how quickly things have changed for investors.

Even 5-6 years ago, someone that wanted to buy bonds had to do it the hard way. They would buy the bonds through their broker, either online or by calling them up. In general, you get a price that you can then buy or sell. If you have decent size (like $XXX,XXX), you might be able to negotiate a slightly better rate.

Now you did get exposure to that bond you wanted but the downside is that you have little to no diversification. So ideally, you buy a few different bonds like this. Now let’s look at the quotes of a bond that you might typically see:

Bid: 103.20
Ask: 105.50

Let’s imagine that the fair price of this bond is in the middle so 104.35… The critical part is that someone buying this bond will lose about 1% instantly on this bond! If you were to get similar quotes on a stock like Apple (same %), it would look like this:

Bid 524.42
Ask 536.10

When in reality this is how Apple trades:

Bid 530.25
Ask: 530.26

Can you imagine trading in a market like this? If you simply buy and sell 1 share, you basically lose 2% of your money.. Would you trade in such a market? That makes a major difference!

The ETF Way

Of course, the big difference is that big institutional investors and funds buy bonds millions of dollars at a time. By doing that, they get much better markets and can trade in a way that is much more comparable to how stocks are traded. The key here is that thanks to bond ETF’s and mutual funds, you can get all of the advantages of these big funds, get very solid diversification, all for a very reasonable fee. The fact that the biggest bond fund in the world, Bill Gross’ Pimco Total Return has launched an ETF that charges 0.55% of annual fees. That seems like very little to pay. Owning such a fund or alternatives like Vanguard’s Total Bond Market gives exposure to hundreds and even thousands of bonds, something that is nearly impossible to achieve without investing tens of millions on your own.

It Would Still Be Great If…

No doubt, I would love to see bonds eventually trade electronically so that smaller investors such as you and I could also get access to decent pricing. However, that is very unlikely to happen anytime soon. Why? There so many different bond issues that it would be very difficult to pull off technically to have an “exchange”. Also, bond brokers have more to lose by doing this. Why? Right now, in markets like these, bond brokers make big spreads on every trade with retail/smaller investors… why give this up? It’s the same thing for all off-exchange products.

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