69 Bond Markets

Most individuals purchase bonds via a broker or through bond funds.

Bonds are bought and traded mostly by institutions like central banks, sovereign wealth funds, pension funds, insurance companies, hedge funds, and banks. Insurance companies and pension funds have liabilities which essentially include fixed amounts payable on predetermined dates. They buy the bonds to match their liabilities, and may be compelled by law to do this. Most individuals who want to own bonds purchase bonds via a broker or do so through bond funds. Still, in the U.S., nearly 10% of all bonds outstanding are held directly by households.

Buying a bond involves setting up an account with a broker and requesting that the broker buy bonds on the buyer’s behalf. Brokers also can furnish considerable market information regarding prices, products, and market conditions. Like with stocks, accounts can be set up with an online discount broker to buy bonds while paying lower transaction fees. It is a good idea to look at several different brokers and their commission rates and services before choosing one. Additionally, bonds can be purchased directly from the U.S. federal government without the use of a broker and without paying broker commission fees.

An individual can also purchase bonds by investing in bond funds, which hold baskets of bonds rather than competing for individual bond sales. Bond funds typically pay periodic dividends that include interest payments on the fund’s underlying securities plus periodic realized capital appreciation. Bond funds typically pay higher dividends than certificates of deposits (CDs) and money market accounts. Most bond funds pay out dividends more frequently than individual bonds. Fund managers provide dedicated management and save the individual investor from researching issuer creditworthiness, maturity, price, face value, coupon rate, yield, and countless other factors that affect bond investing. Bond funds invest in many individual bonds, so that even a relatively small investment is diversified.

Price Transparency

Since bonds are traded in a decentralized, over-the-counter market dominated by dealers, there can be a lack of price transparency.

In economics, a market is transparent if much is known–by many– about what products, services, or capital assets are available at what price and where.

There are two types of price transparency:

1. Knowing what price will be charged to me
2. Knowing what price will be charged to you

The two types of price transparency have different implications for differential pricing. Bond markets, unlike stock or share markets, sometimes do not have a centralized exchange or trading system. Rather, in most developed bond markets such as the United States, Japan, and western Europe, bonds trade in decentralized, dealer-based, over-the-counter markets. This convention, combined with the large number of debt issues outstanding, is largely responsible for the lack of price transparency that exists in the fixed income markets.

Poor transparency contributes to investor differences in bond valuations, as well as other inefficiencies that may lead to economic losses for market participants, and, ultimately, inhibit business development. In such a market, market liquidity is provided by dealers and other market participants committing risk capital to trading activity. In the bond market, when an investor buys or sells a bond, the counterpart to the trade is almost always a bank or securities firm acting as a dealer. In some cases, when a dealer buys a bond from an investor, the dealer carries the bond “in inventory. ” In other words, the dealer holds it for his own account. The dealer is then subject to risks of price fluctuation. In other cases, the dealer immediately resells the bond to another investor.

Bond markets can also differ from stock markets in that, in some markets, investors sometimes do not pay brokerage commissions to dealers with whom they buy or sell bonds. Rather, the dealers earn revenue by means of the spread, or difference, between the price at which the dealer buys a bond from one investor–the “bid” price–and the price at which he or she sells the same bond to another investor—the “ask” or “offer” price. The bid/offer spread represents the total transaction cost associated with transferring a bond from one investor to another. In summary, since bonds are traded in a decentralized, over-the-counter market dominated by dealers, there is a lack of price transparency for bond markets.