Bond buyers take note: Smaller lots may be better

(MoneyWatch) Over the past few years, the spotlight has shown brightly on the costs associated with buying and selling bonds. For instance, one study showed that the larger the size of bond purchases, the lower the trading costs. However, there are times when buying smaller lots can be advantageous.

One of my favorite expressions is that there's only one right way to see things, and that's in the whole. The problem is that those who focus on trading costs are getting only half the story. In fact, purchasing smaller lots often ignored by institutional buyers can offer enough additional yield to more than make up for the higher trading costs. Consider the following example we found on April 5.

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A $1.75 million block of Lewisville, Texas, general obligation bonds, rated AAA and due February, 15, 2020, was being offered at a yield of 1.4 percent. Meanwhile, a Williamson County, Texas general obligation bond with the same maturity and credit quality was offered with a yield of 1.55 percent, though the amount offered was just $50,000. While the trading costs will be slightly higher for the higher-yielding Williamson County bond, the yield to the investor will be higher.

In practical terms, purchasing smaller lots might result in reducing the yield by perhaps 0.02 to 0.04 percent on a bond with a five-year maturity. However, these lots may have yields of 0.15 to 0.50 percent (or even more) greater than available on the large lots where institutions compete. And it's the yield the investor earns that matters, not the size of the bid-offer spread.

To complete the picture, we need to note that when you buy a smaller lot you will own a bond that is a little harder to sell. If you need to sell before maturity, your trading costs will likely be a bit higher. On the other hand, most individual bonds are bought with the intent to hold to maturity. In addition, for liquidity purposes investors should consider holding some assets in a mutual fund, money market account, and larger lots, where trading costs are minimized.

Image courtesy of Flickr user 401(K) 2013.