Market turmoil of late has even hard-core stock investors wondering if they should try a bond or two. They are aware that bonds, too, carry risk, such as an interest-rate rise that makes them worth less.
But there is another bond-buying risk that is much less appreciated: You don’t know whether you are getting the bond at a good price.
Stanley Grandon thought he was. The Michigan eye surgeon bought almost $44,300 in top-rated municipal bonds in a 1995 transaction. He paid $97.41 per $100 face amount. But when he got his next Merrill Lynch & Co. account statement just six days later, they were valued at only $88.78 each–even though bond prices had risen in the interim.
It didn’t take Grandon long to conclude that Merrill had sold him the bonds at a premium price. He estimated that the brokerage firm had sold them to him for as much as a 10 percent markup, for about a $4,000 profit. He sued the firm, alleging that its markup was excessive.
Merrill denies that. “Our practice was entirely within industry norms and standards,” a spokesman says. After noting, correctly, that it was under no obligation to tell Grandon about its charges, the brokerage firm says its bond markup was much smaller than he estimated; it says it bought the bonds itself at $95.36, so its markup was only 2.15 percent, or about $950.
As for the far lower value shown on Grandon’s account statement, Merrill says that was only a rough estimate.
The surgeon’s suit, initially dismissed, was reinstated in June by a federal appeals court, which took a swipe at industry practices. While “it is not for this court to become a rate-setting body,” Judge Joseph McLaughlin wrote, “yet we must also seek . . . to protect customers from paying excessive markups that, because they remain undisclosed, are fraudulent.”
Regulators have long regarded the absence of precise and up-to-date information about bond prices as one of Wall Street’s big failings. Last month, the Securities and Exchange Commission’s chairman, Arthur Levitt, said that this needs to be fixed. In a speech in New York, Levitt said the SEC will work with the National Association of Securities Dealers to develop systems to receive and distribute corporate bond transaction prices to investors.
Price information about municipal bonds such as the ones Grandon bought may follow. As for Treasury bonds, there is a little more information about them available, because prices of some issues are carried in newspapers and dealers have to disclose how much they charge other dealers for bonds–though not how much they charge investors.
“The sad truth is that investors in the corporate bond market do not enjoy the same access to information as a car buyer or a home buyer or, I dare say, a fruit buyer,” Levitt said. “Improving the transparency is a top priority for us.”
The House Commerce Committee plans hearings soon to explore bond pricing, which is mainly a concern with bonds in the resale market. “It is time to open up public access to market information that previously has been closely held by the broker-dealer community,” says a panel member, Rep. Edward Markey (D-Mass.).
Stocks are traded in public exchanges and through dealers that post changing prices almost instantly. Thus, investors typically are able to find the best price on a particular stock and know precisely what price was paid to buy or sell a stock. Brokerage commissions and other fees are clearly stated in confirmation slips and monthly statements.
Bonds are different. Although the roughly $350 billion of bonds traded each day in the U.S. dwarfs the $50 billion of stocks that change hands, almost all bond trading is done “over the counter.” Someone who wants to buy or sell a bond calls a broker and asks for a price quote. The broker is free to name virtually any price, because there is no effective reporting mechanism that an investor can turn to for information about the latest trade in a particular bond.
Why not call a lot of brokers and ask each for a price quote? The problem here is that brokers often insist that a caller set up an account before they will quote prices.
Unlike stockbrokers, bond dealers don’t just act as agents for buyers and sellers. Bond dealers are themselves the owners of the bonds the investor buys. There is usually no commission, but that doesn’t mean the investor pays nothing to get the bond; the bond dealers earn money by marking up the price of bonds sold to investors and marking down the price of those bought from investors.
Levitt says his late mother, Dorothy, once remarked to him how wonderful it was that bond brokers didn’t charge commissions. “She thought it was the greatest thing that ever happened to her,” Levitt says. “I tried to explain to her about markup charges, but she didn’t want to hear it.”
Bond brokers say there are reasons markups must sometimes be high. Bond brokers buy a block of bonds to hold in inventory, counting on selling them to customers at higher prices than they paid. By holding the bonds, the brokers run the risk that the market will fall, reducing the value of their holdings and making it difficult or impossible to sell them at a profit. In addition, bond brokers ordinarily stand ready to buy bonds from investors who want to sell them at any time.
The risks facing bond brokers have been particularly evident in recent weeks as prices of corporate, municipal and foreign bonds have been highly volatile amid global market turmoil. Bond dealers with heavy inventories of such bonds have suffered punishing losses.
Further, while the number of stocks traded in the U.S. is only about 15,000, there are about a million different bonds, most of which don’t trade regularly. Without frequent trades, the industry argues, it is difficult to provide up-to-date prices.
Bond dealers contend that investors need only look at the yields on the bonds they buy and needn’t be concerned with how much a brokerage firm makes by marking up a bond. A bond’s yield varies inversely with the price: The higher the price for a bond, the lower the resulting yield.
“If markups were provided, customers might get distracted and look at them and not the yield, which is more important,” says Christopher Taylor, executive director of the Municipal Securities Rulemaking Board, a self-regulating body of municipal bond dealers.
But regulators say there is an obvious flaw in that reasoning. “The yield is the most important factor when buying a bond, but you need to know if the yield is appropriate for your bond,” says Robert Colby, the SEC’s deputy director of market regulation. “A 5 percent yield may be terrific, but it isn’t terrific if it could have been 5.8 percent for that bond” if the price had been lower.
