Investors who trade individual stocks probably know how much commission they pay their broker for each trade. Same for most mutual funds or options. But for investors who choose to buy individual bonds, figuring out the commission may be more difficult.
Bond dealers collect commissions on bonds they sell, but these commissions, commonly called "mark-ups," are bundled into the price that's quoted to investors. Typically, most brokers do not reveal mark-ups to customers prior to purchase, so some investors may not even realize they are paying a fee.
New regulations that took effect in May 2018 require all brokers to publish their mark-ups on certain types of bonds—but only after the transaction.
It's important to understand how transaction fees impact a bond’s yield. Spending less on bond trades can help improve your returns over the long run. Here we demystify how bonds are priced, and how you can comparison shop.
A fragmented, opaque market
Only a tiny portion of the 1.1 million bonds currently available are sold over public exchanges like the New York Stock Exchange, where investors can easily browse available securities and receive up-to-the-minute pricing information.
Instead, most bonds are traded "over the counter" between brokerage firms and their customers, or from one dealer to another. The brokerage firm that buys a bond on your behalf typically won’t show you all the relevant pricing data, such as the price it paid to acquire the security. Instead, the firm will simply quote you the bond's yield and the price you will pay, without saying how large a mark-up is included in that price.
Mark-ups are akin to the difference between the wholesale price for an item and the retail price in a store. In theory, a mark-up helps brokers cover expenses related to acquiring and selling the bond on behalf of clients, as well as ongoing costs related to custody and recordkeeping, and making a profit.
The challenge for investors is that they often don't know how much they’re paying. And mark-ups for the same bond at different firms can vary—sometimes dramatically. And, there is no easy way to compare mark-ups.
The true cost of mark-ups
The cost of bond mark-ups can have a big impact on the yield you generate from your bond portfolio. For a given bond, the higher the price you pay, the lower the yield you'll receive on your investment; the less you pay, the higher the yield.
Imagine buying a single $1,000 bond with a 4% coupon maturing June 1, 2028, priced at its par value of $100. Add in a $20 per bond mark-up and your yield-to-maturity drops from 4% to 3.76%. Reduce the mark-up to $1, and your yield is 3.99%. That 23-basis-point difference can add up. If you bought 22 bonds, the average size purchase at Fidelity, you’d save roughly $400 in expenses with a $1 per bond mark-up versus a $20 mark-up.
Bond mark-ups vary widely by issue, order size, and broker. Standard & Poor’s estimates that the average mark-up is 0.85% for investment-grade corporate bonds and 1.21% for investment-grade municipal bonds.* But actual mark-ups can range from as little as 0.1% to as high as 5% of a bond's par value, or from $1 to $50 per bond.
To better understand the range of bond pricing, Fidelity commissioned research firm Corporate Insight to compare bond prices of the same bonds offered online across several broker dealers. The February 2018 study found dramatic variation. The average online prices for corporate and municipal bonds at certain competitors were found to be an average of $13 more, per bond, when compared to Fidelity's prices when including our $1 mark-up per bond (see table). What's more, the cost differential grows with maturity: you tend to see higher mark-ups on average in longer versus shorter maturity bonds.
How to learn what you’re paying
So how do you know what your broker is charging? Begin by asking. Most brokers should be prepared to answer honestly and directly. If your broker seems evasive, you have every reason to be suspicious. It’s also a bad sign if they claim there is no mark-up, because "no mark-up" is almost never the case.
You can also comparison shop. Comparing bond prices at different brokers is trickier than comparing the price of a refrigerator at 2 different stores, but it can be done. If you have accounts with different brokerage firms, you can log on and check whether they offer the same bond, then compare the prices, which include the mark-up. This won't always work, however, because not all brokers offer the same bonds.
An easier option is to review real-time trade reporting data provided by the Municipal Securities Rulemaking Board (MSRB) and Financial Industry Regulatory Authority (FINRA).
Prices and yields change from day to day. By using the historical trade data from MSRB and TRACE, you can see where prices and levels have been trading in the recent past and compare them to the current live offer or bid prices. In addition, by comparing customer prices with dealer-to-dealer prices for trades executed for the same quantities at the same time, MSRB and TRACE data provides increased transparency into the mark-ups that bond brokers are charging their clients. As you can see in the example, mark-ups and yields can vary a lot:
"Fair" pricing is a personal decision
What makes a mark-up fair and acceptable? It depends in part on personal opinion. Investors who have a strong relationship with a broker and value the service he or she provides might feel more comfortable paying slightly higher mark-ups. However, many investors likely will find lower mark-ups more attractive—especially considering the impact mark-ups have on yields.
Take advantage of your knowledge about how bond mark-ups work to compare the service and prices offered by different brokerage firms or bond dealers. Besides comparing actual prices, gauge how transparent different dealers are about revealing those numbers and what goes into setting them. Greater transparency may give you greater peace of mind. The bond market may once have been a murky place, but the combination of new regulation and technology is steadily improving transparency. You don't have to stay in the dark about the cost of your bond investments anymore.
Next steps to consider
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