The Hidden Costs Of Investing In Corporate Bonds And Other Semi-Liquid Assets

Frequent trading in and out of corporate bonds and other semi-liquid assets can quickly erode your returns. There is a great cost to liquidity and in most cases, these transactions involve paying off multiple middle-men as we will see in our example below:

Let’s take a look at a hypothetical transaction for Apple (NASDAQ:AAPL) 2.4 ’23 bonds.

We can look to Bloomberg to see a “mid-market” or hypothetical fair value for these bonds. One way to look at this value is to think of it as the price at which a dealer who is un-axed (meaning they have no position) would be indifferent between buying and selling. Right now that price is $101.442. In bond terms, that means the bond is trading at 101.442% of face value or in other words, $1014.42 per bond.

Now let’s suppose you were to buy such a bond, is that the price you’re going to get? Absolutely not. Let’s examine the process the bond has to go through to finally get to you.

First, you would have to go to your broker and give them an order. Your broker is then going to have to source these bonds somewhere. They’re likely to go to an ECN or electronic communication network to get a quote from a dealer, who is marking a market in the security. The dealer is willing to buy bonds at slightly below the fair market value and sell them at a slightly higher price. Dealers are, in effect, providing liquidity to the market for a fee.

Each of these three parties takes a cut of the action.

First, the dealer is making a market in the security. If $101.442 is the fair price, then dealers would certainly have to sell at a higher price to make money, so your broker might get back a quote of $101.500. Of course, the ECNs won’t work for free either. In order to use their platform, your broker will have to pay a fee as well, and after this, the price might be $101.520. Lastly, your broker will either charge you a commission or a markup (if sold from inventory). Finally, after all this, the net cost to you might be something like $101.625.

At the price you saw of $101.442, the yield of this bond was 1.995% but at $101.625, the yield is now only 1.945%, you’ve lost a whole 5 basis points. In dollar terms, you’ve paid roughly $1.80 per bond. If you were to then exit your transaction, you’d pay a similar set of fees on the other end. Our bond trades at 47 z. At 10 basis points a round trip, if you were to trade in and out just once per year, by the time these bonds matured, you would have made zero compensation for your risk.

Keep in mind, the example I gave was for very liquid Aa1/AA+ rated AAPL bonds. For riskier and less liquid high yield bonds, the dealer bid/ask spread, the ECN fee and the markups all become much higher.

If we were to look at some high yield bonds, a reasonably liquid B might trade at 0.5 to a 1 point spread. On top of that, a broker would probably charge another whole point in markup. From end to end, that could mean a whole 3% of face value taken out of a round trip. Trading twice per year would completely eliminate your yield and that’s not accounting for the risk-free-rate!

Thus, it is incredibly important to consider the transaction costs when transacting in semi-liquid asset classes. For those of you with smaller portfolios, it is probably best to consider alternatives to investing in individual securities such as ETFs or mutual funds. Typically, both brokers and ECNs have minimum ticket costs and so as a percentage of face value, the fees go up drastically for small transactions. Furthermore, as we’ve seen, frequently trading in and out of positions is incredibly expensive, and so it is probably best to engage in these positions only if you have a long investment horizon.

Hope this article helps everyone to better understand the costs associated with investing in bonds and other semi-liquid asset classes. If you enjoy my articles please support by subscribing!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.