The games brokers play -- at your expense

(MoneyWatch) One of the morals of fairy tales is that children should be wary of old ladies offering apples or candy. We learn from these tales that it's likely the old lady has a hidden agenda behind her "sweet offerings." We also learn from these tales that their lessons can apply to real life.

While investors don't have to fear poison apples, they should be wary of people trying to take advantage of them. One frequent purveyor of bad fruit they should be wary of: broker-dealers. These firms understand that individual investors' lack of knowledge about the bond market makes exploiting them as easy as taking candy from a baby. The following are just two examples of how brokers exploit investors.

Investors need to be aware that the size of the impact of a markup or markdown on the yield of a bond is negatively related to its remaining term to maturity. For example, a bond with a remaining maturity of just one year will see a return impact of one percent for each one point of markup or down. However, the yield impact is reduced as the term to maturity lengthens because the markup will be "amortized" over a longer time frame.

For instance, a bond with a remaining term of just one year is yielding 3 percent and trading at par. A markup of even 1 percent would be very hard to hide, as the yield to maturity would drop a full 1 percent to 2 percent. On the other hand, if the bond had a remaining term of 10 years, the yield to maturity falls to about 2.85 percent. That is a drop in yield of just 0.15 percent. And if the bond had a remaining term of 25 years, the yield to maturity would fall to about 2.93 percent. That is a drop in yield of just 0.07 percent.

In other words, the longer the maturity, the less the impact on yield and the easier it is to hide the markup.

Now imagine a broker wanting to take a markup of four points on the same bond. That would be very hard to do with a bond with just one year remaining to maturity because the yield to maturity would then be negative -- the investor would pay $104 for a bond that in one year returned his $100 in principal and just $3 of interest. On the other hand, the impact on the yield to maturity of a bond with 25 years to maturity would be only about 31 basis points per annum.

I don't think it is hard to guess which maturities brokers push when selling bonds to individual investors. Unfortunately, not only do investors end up paying large transaction fees, but they also ending up taking far more price risk than might be prudent.

Another example of how brokers exploit individual investors is by selling them premium (above par, or 100) bonds that have call dates that are much closer than the maturity date. The bonds sell at a premium as a result of their high coupons (the attraction) relative to current market rates. Again, an example will help to illustrate how brokers both take advantage of the opaqueness of pricing, and also exploit an investor's lack of knowledge about bond pricing and the risks of fixed income investing.

Imagine a bond with a remaining term to maturity of 25 years and carrying a coupon of 6 percent. The current market rate for similar bonds is now 4 percent. The bond has a call date that is only one year away. Despite the relatively high coupon and the long remaining term to maturity, the bond should not be trading much above par because of the nearness of the call date and the high likelihood that the bond will be called by the issuer.

Let's assume the bond is trading at about $102 (because the coupon is 2 percent above current market rates and the investor can expect to receive the higher yield for just one year). Now the broker decides to add a markup of five points and sells the bond to the investor at $107. The broker will tell the investor that the yield-to-maturity is about 5.6 percent, well above current market rates. (Remember from our prior example how long maturities effectively camouflage the size of the markup.)

Unfortunately, the bond will almost certainly be called in one year. Assuming it is called at par, the investor will have earned the coupon of 6 percent and lost seven points in price, producing a net loss of 1 percent. As you can see, the investor was actually sold a bond with a negative expected return! This is not as rare as you might think. But it gets worse. When the bond is called, the broker will call the investor to advise him of the call. The investor now has to reinvest the cash, and the broker gets to play the same game all over again.

A less extreme example would be if the call date was in three years instead of just one. In this case the price of the bond in the wholesale market would be around $106. With the same markup of five points, the bond would be sold to the investor at $111. If the bond is called at $100 in three years, as is likely, then the investor would have earned a return of less than 3 percent (having earned the coupon of 6 percent but also having to amortize the premium of eleven points over just three years).

The above examples illustrate how important it is to be an educated investor. Hopefully, they also have convinced you that while education doesn't have to be expensive, ignorance can be very expensive when you have brokers who don't have their clients' best interests at heart. You deserve your fairy tale ending -- or investment returns -- but with misleading brokers, the results can be grim.

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