Statistically, not many people invest in corporate bonds, and it isn’t any secret why. If you’re looking for bond exposure, you can get US Treasury bonds and notes that are fully guaranteed by the US Government. Of course, you can also buy bond funds that will handle all the details for you, including diversification. So, why would anyone buy a corporate bond?
Yield. According to Moody’s, the current seasoned AAA corporate bond yield is 4.06%. That’s higher than the rates currently being paid on US Treasury securities of any term.
But, getting the high yields that corporate bonds pay is another story. The fees involved in acquiring corporate bonds seriously diminish the net yield, which is a big part of the reason so many investors avoid them entirely. Still, that doesn’t mean that there isn’t money to be made if you trade corporate bonds correctly.
The High Cost of Buying Corporate Bonds
A Wall Street Journal article (Huh? It Costs How Much to Trade a Bond?) cites a study conducted by University of Southern California finance professor, Lawrence Harris, that spells out the details on the high cost of buying corporate bonds.
The WSJ article noted the following:
“Prof. Harris analyzed bond-price quotations gleaned through Interactive Brokers Group, the deep-discount brokerage firm where he is a member of the board of directors, and trade data from the Financial Industry Regulatory Authority. He estimates that individual investors are paying bond dealers and other middlemen an average of $7.72 per $1,000 of principal value to buy corporate bonds. If you paid that much to buy stocks, 200 shares of a $50 stock would run you at least $77.20 in trading costs—instead of the roughly $10 that you would pay at most online brokerage firms.”
Taking $7.72 in purchase costs into account, the 4.06% current seasoned AAA corporate bond yield falls to 3.288% when the bond is held for just one year (4.06% – 0.772%). Or taken another way, the $7.72 in bond buying costs nullifies the first 2.3 months of interest received from the bond. And, that assumes that there no costs required in order to sell the bond on the backend.
The Wall Street Journal goes on…“The structure of the bond market is ‘terrible,’ says Prof. Harris. ‘Corporate bonds are ridiculously expensive to trade,’ he says, ‘because dealers get the best prices for themselves, then deliver crappy prices to customers.’ ”
Given the high cost of buying corporate bonds, it’s obvious that trading them on a short-term basis will be difficult to do profitably.
How to Buy a Corporate Bond
If you choose to invest in individual corporate bonds despite the high costs, there are a few strategies you can use to minimize the impact and improve your return.
Buy corporate bonds through funds. This is a topic all its own, and we’ll get to it in some detail in the next section.
Buy high quality bonds. Lower quality bonds, with their higher interest rates, will allow room for even higher broker fees. In addition, the greater volatility of lower quality bonds may necessitate an unexpected short-term trade in the event that you need to get out in a hurry.
Monitor the market and specific bonds before buying. This should be the case for any investment into individual securities, but it goes double for corporate bonds because they are so expensive to trade. Check out and research the Financial Industry Regulatory Agency’s (FINRA) Corporate Bond Data for one of the most comprehensive bond monitoring platforms available. There you will find a wealth of market information, as well as data on the individual corporate bonds that you are interested in buying. This is also an excellent way to determine if your broker is giving you a fair deal on the bonds you want to buy.
Don’t be shy about haggling with your broker. There may be some wiggle room in the price of bonds that your broker can get for you. If your broker offers you a bond at 101, offer 100.50. You might settle in the middle at 100.75, which will give you a 0.25% advantage just for your effort.
Take advantage of Limit Orders. This is a trading tool that enables you to set an upper limit that you are willing to pay for a security. It is most often done with stocks, but it can also be done with bonds. If you think that a bond is attractive at 101, but it’s currently trading at 101.5, set a limit at 101, and be prepared to wait. Your broker may even work to make it happen, giving you the benefit of the lower price without having to go the haggling route. Just be aware that a brokerage firm may charge a surcharge if the limit order is done through an account rep rather than online.
Bond Funds: The Better Way
Since buying individual corporate bonds is so expensive, it’s generally better to have your bond holdings held through either mutual funds or exchange traded funds (ETFs). In fact, this is the way the great majority of investors invest in bonds, corporate or other kinds.
There are several advantages to investing in corporate bonds through bond funds:
- Professional management – Investing in corporate bonds is a true specialization. You’re not just looking at yields, but also at the underlying strength of the issuing company. Timing factors and overexposure issues are also considered. Bond funds are run by professional bond managers, and they have a skill level that the ordinary investor doesn’t.
- Avoiding trading fees – Though it may be expensive to buy corporate bonds for ordinary folks like you and me, bond funds can “buy in bulk” – which is to say that they’re paying less in transaction fees than we would. There is a lot more bargaining power when you are purchasing a $1 million bond position than just one for $10,000.
- Transparent pricing – Since every fund publishes fees and expenses that will be charged to investors, you’ll know exactly what they will be. This is unlike investing in individual bonds, where the total amount you will pay in fees over the course of a year will be subject to change based on trading activity.
- Diversification – Bond funds can invest in a larger number of individual bonds, which provide a level of diversification that you won’t be able to achieve on your own unless you have several million dollars to invest.
- Simplicity – One of the biggest advantages to investing in funds is that all you need to do is a) choose the fund you want to invest in, and then b) decide on what your allocation will be. That means you can invest in bonds, without getting involved in all of the intricacies involved in that effort.
Where do you find the best bond funds to invest in? We’re not going to make specific recommendations as to funds, but you can find the best rated in performing bond funds through various sources. One of my favorites is the US News Best Fit Corporate Bond list of the 34 top corporate bond funds for 2015.
Individual Bonds: Low-Cost Brokers to the Rescue
If you’re still interested in trading individual corporate bonds, plan to do so with a low-cost brokerage firm. Here are some of the lowest in regard to corporate bonds:
- TradeKing – $1 per bond with $10 minimum, $250 maximum, per transaction
- E*Trade – $1 per bond with $10 minimum, $250 maximum
- Charles Schwab – $1 per bond with $10 minimum, $250 maximum
- Fidelity Investments – $1 per bond with $8 minimum, no maximum indicated
- Interactive Brokers – 0.1% of face value if face value is $10,000 or less, 0.025% of face value if face value is greater than $10,000, no minimum or maximum charges
Note that brokerage firms typically charge much higher fees on broker-assisted trades. Fees included above represent those charged for online transactions only.
Do you buy individual corporate bonds or do you invest in them primarily through mutual funds and ETFs?Topics: Investing