Mark-up Disclosure for Bonds: It’s About Time
I’ve spent the better part of a decade trying to explain to investors that bond purchases are not free. But that’s a difficult task when the costs are hidden from investors. This will change in May 2018, when the SEC’s new bond mark-up disclosure requirement takes effect.
What is a Mark-up?
Unlike stocks, where investors receive a confirmation that explicitly lists the transaction fee or sales commission, bonds are offered to investors out of a broker-dealer’s inventory. The broker-dealer firm buys the bond at one price, then “marks up” the bond and sells it at a higher price to its customers. There’s nothing wrong with the broker-dealer receiving compensation for functioning as a liquidity provider between buyers and sellers. The problem is that mark-ups have never been disclosed to investors. As a result, investors do not have an opportunity to compare costs and create a market price for these transaction costs. While the costs to trade stocks, ETFs, and mutual funds have come down dramatically, bond transaction costs remain a mystery.
Here’s an example of a mark-up in action:
Source: https://emma.msrb.org/
This is real trade data from May 31, 2017 for a municipal bond from Illinois.
At 3:10pm a broker-dealer purchased 50,000 bonds for $100.9 for a total purchase of $50,450.
At 3:33pm the broker sold pieces of this bond to two customers for $102.679. One customer bought 10,000 bonds and paid a mark-up of $177.90, and the other bought 20,000 bonds and paid a mark-up of $355.80.
At 3:45pm the broker sells the final 20,000 bonds to a customer who pays a mark-up of $355.80. Total mark-up earned by the broker-dealer and paid by the customers = $889.50 or 1.76%.
For perspective, a commission rate of 1.76% to purchase 100 shares of Apple stock would be $269.60. Online brokers charge between $10 – $25 for this type of trade.
Arguably bonds do not trade on exchanges and require broker-dealers to take risk by holding them on their balance sheet as inventory, if only for a few minutes. This requires broker-dealers to employ more traders to handle bond transactions. I’m not implying the bond trades should cost the same as stock trades, but what I do know is that consumers have no idea what they’ve been paying to buy bonds. That will change next year.
Disclosure Requirements
Beginning in May 2018, mark-ups must be disclosed to investors on trade confirmations. Specifically, the broker-dealer must disclose a mark-up if it sells a bond to you out of its inventory, which is also known as a principal transaction. Additionally, the trade confirmations must include a hyperlink to a website containing publicly available data for the specific security traded. This will allow investors to see exactly what time (to the second) the broker-dealer purchased the bonds it sold to them at a what price.
Sunlight is the best disinfectant. Mark-up disclosure is long overdue. It will give investors a chance to compare prices and will create competition among broker-dealers. This is good for investors. Broker-dealers and their sales representatives will have to make adjustments to their business models. I suspect that long gone are the days of charging customers “2 points in and 1 point out.”
Footnotes:
1) Based on closing price of $153.18 per share on June 1, 2017.
2) A common mark-up charged by brokers to retail customers is 2 points (2%) to buy and 1 point (1%) to sell a bond.
