The Opaque Bond Market

We tend to think of bonds as the most boring investment imaginable. No one’s really too worried about the U.S. government defaulting, after all, and even most U.S. municipalities have credit ratings impeccable enough to ensure that buying a moon bond is like putting your money in the bank. In fact, though, bonds have actually been more risky–in terms of their inflation-adjusted return–than stocks for most of this century. The flip side of that is that there have been sustained periods when bonds have outperformed stocks as investments. We’re in such a period now, as the bond market has taken off, driving prices to historic highs and the yield on the 30-year long bond to near 5 percent. It’s taken the bond market a long time to recognize the reality of deflation, but now that it has, the safety of U.S. equities and a still relatively high real interest rate have sent money flooding into both government and corporate bonds.

Frustratingly, though, the strength of the bond market has not translated into any meaningful reform of that market’s complete lack of transparency. Although most people assume that when you buy a bond you hold it until it matures, in fact you can trade bonds just the way you can stocks. Or rather, you should be able to trade bonds the way you trade stocks, which is to say you should be able to check a price quote on the bonds you own, call or e-mail a broker, and sell your bonds at the price offered. The reality is, if you’re an individual bond-owner, you can’t do anything like that.

It’s more likely that you’ll call your broker, wait a little while, and then be quoted back a price that’s below the price you read in the Wall Street Journal the day before. Or, if you wanted to buy bonds, you’d be quoted a price well above the previous day’s close. The bid-and-ask spreads on U.S. treasuries tend to be small, since that is the most liquid market in existence, but spreads on many corporate bonds, on municipals, and on foreign bonds are often as large as five or six percent. It’s kind of hard to make a meaningful profit when you’re giving up give five percent every time you trade.

The market works this way because bonds are still traded almost literally over-the-counter, which is to say that there’s no public forum where bid-and- ask prices are quoted, and there are no market makers who agree to buy and sell bonds in order to keep the market liquid. As a result, your broker calls other people, and depending on whom he calls, you may get a good price or a bad one. And since few people have more than one bond broker, it’s kind of hard to comparison shop. Most brokers won’t even quote you both the bid and the ask.

But while the lack of liquidity explains some of the price inefficiencies in the market, it’s not the whole answer. After all, if you have a good to sell that people want to buy, you shouldn’t have to sell for significantly less than the last person who sold that same good did. The prices of both transactions should be relatively close. The real problem here, then, is that the person buying (or selling) the bonds is not the person paying for the bonds, which is to say that brokers have no real incentive to push for the best price because they’re not rewarded if they do or punished if they don’t. In fact, since your broker will often be selling your bonds to a trader in his own brokerage house, he probably has more of an incentive to get you a bad price. And in the absence of clear information–most brokerages don’t even give their bond customers a regularly updated account of the value of their bonds– it’s hard to say that you’ve been rooked. Even though you have been.

The lack of transparency in the bond market doesn’t appear to be eroding the appetite for bonds. But the funny thing is that the market is so un-transparent that people don’t even know that it is. Not until you actually try to sell a bond, after all, do you realize what’s going on. And in any case, insofar as markets work well, it’s because they are transparent, and permit goods to be bought and sold at the price the collective market determines. In the next year, the SEC should occupy itself with bringing the same level of transparency to the bond market that we now have in equities.