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Subject:  Bond Brokers & Bond Desks Date:  7/19/2006  5:07 PM
Author:  imdajunkman Number:  17591 of 35357

Post 9/11, I bought 2-year and 3-year corps rather than follow Treasury yields down. Most will perform as expected. The bonds will mature, and I'll make the spreads I traded for. Sea Containers is a likely exception. The company is in trouble, and default is a possibility. My entry was an imprudent 101.600. But I paid the premium to obtain the 10 ¾ coupon. Monday, my broker breathlessly called, saying news was bad and asked if I wanted to get out. I did some quick DD, decided he had misread the market, and declined. (The fuller story was told in a prior post). The bonds weren't crashing. But I did have to ask myself, upon reflection, why I was holding them, now only three months from maturity. The traderly thing would be to take a loss on price, but lock in accrued interest, and move on. “Sunk costs” are nonsense and not a reason to hold a position. I saw them trading at 96, so I called him later, asking what price I could get.

He bemoans the fact that I didn't call him two hours earlier when he was putting together his afternoon's order. I asked him what price he got. He doesn't recall, but looks for his ticket, and tells me it was 94x50. Sure enough, I find his trade in the T&S made available at www.investinginbonds.com , now that he's identified it. But he's not doing his clients any favor. He's hitting low bids to get the trade done. (True, that's sometimes what you do. If you need to get out, you take the price you can.) It's now late in the day, and he argues that putting out an offer is a waste of time.

Yesterday, the MM's (the marker makers) opened trading in Sea Containers' bonds late for wanting to guage the news and customers reactions before they made a market. (That's their privilege and why they can trade against you so profitably. They can see the order flow.) Today, trades are happening fairly soon into the session, and I also pull the news. SCR has executed their sale of property, and the market likes it. The stock has jumped 23%, and the bonds are printing at 96.500 on block orders, not the small stuff of yesterday, with the bid advancing, though the ask is a ridiculous 101 (subsequently adjusted to 100 and then 98). My position has become a distraction. So I e-mail him to step in front of the offer and offer me out at 97, accepting nothing less than 96.500. That's where the market is. That's what I want. Shortly, I get an e-mail to call him. The best bid from anyone for my bonds was 95.160. Did I want to accept? He says, “The position is only 5 bonds. That's what happens when you try to sell just 5 bonds, and why I want you to buy ten. You're going to have to take a point or two less for five.”

Now, let's step back and ask what's going on. At IB I could write my own orders and either make a price or take a price without broker intervention. I'm not holding the bonds at IB. So I've got to trade them through Joe. Collusively, all brokers, all desks, hate dealing with “small orders”. E.g., Scottrade requires the order to be ten bonds. E*Trade imposes a commission of $40-45 on less than ten bonds, plus their usual markup. Fido has no set minimum, shows the inside market, and has a $20 minimum commish. (But their inventory is meager.) IB also has no size minimum and has $5 min commish, shows the inside market, plus allows the customer quasi-direct access by facilitating the writing of orders. In other words, you can make prices, and you'll see them posted nationally in real time. True direct-access to exchanges is offered to stock/futures traders. But for bonds, there are no comparable exchanges, nor will there ever be, because the institutionals don't want the riff-raff in their cozy club. Profit margins would decline. They've seen what's happened in the stock market to spreads and commish and don't want the same to happen to them.

So the game they are playing is this: require your customer to trade ten or more bonds, mark the bonds up if they're buying (down if they're selling), and charge as much commish as you can. Total extortion. The technology is there to create an electronic market. But the market makers –-the underlying desks either holding the bonds or trying to obtain the bonds for customers— would be out of business if customers could trade with each other, as they most certainly and most easily can do in the case of stocks and futures. I have no objection to paying a fair commission for the trade. Technology is expensive, as is the back-office support. But if IB processes bond orders profitably –-and by all accounts and their own admission, they are doing handsomely well with their business model--, why can't other brokers match their prices and platform? Obviously they could/can, but, collusively, they decline to do so. No one is willing to break ranks. They're all hoping IB will go away, and are doing everything they can not to facilitate their success.

Interestingly enough, Joe did concede to me that the bid I got of 95.160 was, in his opinion, a good one. “Well, yes, Joe”, I'm saying to myself. “That was 1.6 points better than you got your clients yesterday on a more marketable size. But that's still a sucky bid, because you pirates are gouging investors with your insistence on large-size trades. Let the small guys into the market-making process, and you'll start seeing plenty of small trades happening and done at very tight spreads. Build it, and they will come.”

But the bond market is what the bond market is, and you either learn to play the game as the game is played, or you find one more to your liking. But that doesn't mean that I don't complain or try to give newbies fair warning. If you're going to buy your own bonds, be prepared for a lot of hassles, but not the kind they warn you about as they try to scare you into funds, which they, conveniently, just happen to market. What's hard about bonds isn't the analysis, which they always claim that most investors could never learn to do. (A claim which is nonsense.) The hassles are in executing. Let anyone have the same ease of execution with bonds that is possible with stocks/futures, and the bond game would be entirely different. But the bond game would no longer be so profitable to the entrenched middlemen. So things aren't going to change very much, or very soon.

They will change some day. Things are much better than they were 20 years ago, 10 years ago, or even 2 years ago. For free, I can pull Time & Sales on bond trades as I could never do before unless I rented an impossibly expensive Bloomberg. I can get historical data for free. Commissions are dropping. Inventory can be searched online 24x7. Etc. Things are definitely better. But when I see how easy the stock guys have it, I do get envious. The stock game is way harder than the bond game. Bonds mature. Bonds come earlier in the credit line. You can't believe what a work-and-worry saver those two features are. They come at a cost of potential returns, but the cost is tolerable.

I love bonds. But sometimes, the game rules can be discouraging.

Charlie

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