Cautions for Bond Buyers

One of my longstanding investment rules is that investors who want to buy individual bonds (instead of bond funds) should buy only treasury bonds and only newly-issued bonds. You also can consider buying tax-exempt bonds if they are new issues. The reason for this recommendation is that the market for individual bonds isn’t nearly as efficient as it is for stocks. You’re likely to pay both markups and commissions on the bond purchases. It likely is cheaper to pay a mutual fund its fees and let them negotiate bond purchases.

Here’s the latest evidence, a survey by The Wall Street Journal. (Subscription might be required.) It found that individual buyers of tax-exempt bonds pay far more to brokers than they do for purchases of corporate bonds, and those are considerably more than brokers receive for corporate stock. Yet, individuals are the biggest buyers of tax-exempt bonds. If you buy individual bonds, hold them to maturity. You’ll lose quite a bit if you sell them to a broker.

Individual investors trading $100,000 in bonds of a municipality, such as Washington state, in December paid brokers an average “spread” of 1.73%, or $1,730. That compares with 0.87%, or $870, paid on a comparable corporate bond, such as one issued by General Electric Capital Corp., the data show.

Brokers of stocks and corporate bonds must disclose market pricing and give individuals “best execution” on trades, ensuring they receive the best prices possible. In the municipal-bond industry, those protections are absent, allowing brokers to pocket higher spreads by buying the bonds low and selling them high.

Individual investors, especially retirees, have long been attracted to municipal debt as a relatively safe investment whose interest payments aren’t taxed. They own 45% of all municipal bonds directly and another 28% through mutual funds, amounting to a combined $2.7 trillion, according to data from the Federal Reserve.