How expensive are your bonds?

When buying bonds, markups can tear through your returns.
taxbrackets.org

(MoneyWatch) Mutual fund expenses you don't know about can have a devastating effect on your portfolio. The same is true for bonds.

It's my experience that many individual investors who buy individual bonds believe that their only expenses are transaction fees, which could be as little as $25 or $50 each. Unfortunately, there are investment firms that prey on retail investors, adding large markups to the price of the bonds they sell.

One reason they are able to do so is that the prices for many bonds can't be found in the newspaper or even online. The lack of visibility in pricing allows for investor exploitation. "When I went to buy bonds for myself, I was stunned at the difference between buying them as an institutional investor and as a retail investor," says Brian Reynolds, a former institutional fixed-income portfolio manager at David J. Bradson & Co.

My friend and fellow investment author William Bernstein put it this way: "The stockbroker services his clients in the same way that Bonnie and Clyde serviced banks."

Jared Kizer, co-author of my alternative investments book and blogger at MultifactorWorld.com, shared a story about a family with $40 million in assets. This family had just sold their business and allocated almost all the money to high-quality municipal bonds. Unfortunately for them, the broker who built the portfolio effectively charged them more than $600,000 for the relatively simple task of building out a bond portfolio. Compounding an already bad situation, the broker charged significantly more fees on trades occurring after the original portfolio was constructed.

How can this happen? As Jared explains:

It's because bond markups don't have to be disclosed. A bond markup is the difference between how much a broker paid for a bond and how much he or she sold it for. In this case, the markups averaged about 1.2 percent, meaning the broker-dealer was essentially buying bonds for $100 and selling them for $101.20. On a portfolio of this size, these are particularly egregious markups.

It's important to note that markups (or markdowns, for that matter) aren't evil. This is the fee that brokers receive for their service of providing you with the bond, and they should be compensated for their work. However, they should be compensated fairly, and unfortunately excessive markups aren't unusual. When you buy individual bonds from a broker, you should ask to see the markup or markdown, which shows how much the dealer is changing the price.

Image courtesy of taxbrackets.org

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.