Personal Finance

Here’s how much your broker makes when you buy a bond

Key Points
  • As of May 14, broker-dealers must disclose the "transaction costs" customers pay when buying and selling corporate and municipal bonds.
  • A 2007 study found that retail investors trading $20,000 of municipal bonds faced an average transaction cost of 2 percent.
  • So-called "mark-ups" and "mark-downs" imposed by your brokerage firm are reflected in the price you pay for bonds.
John Zich | Bloomberg | Getty Images

Let's be honest: Do you actually know much your broker earns when you put in an order to buy a municipal bond?

You'll be able to answer that question today. Starting on May 14, broker-dealers will need to disclose mark-ups and mark-downs they charge on bonds bought and sold to retail investors on the same trading day.

Firms will also have to tell customers the time they executed the trade and provide a reference and a hyperlink to a page detailing the publicly available trading data for the bond.

The rules have been in the works for years: The regulations from the Financial Industry Regulatory Authority and the Municipal Securities Rulemaking Board were approved by the U.S. Securities and Exchange Commission in November 2016.

Now that the regulation is in place, you'll be able to see these transaction fees in a dollar amount and as a percentage of the "prevailing market price" for the bond.

"Brokerages compete pretty significantly to provide cheapest execution on stock trading, but it's not the same in the bond market," said Micah Hauptman, financial services counsel at the Consumer Federation of America.

"This is just the beginning of increased price transparency," he said.

Here's why you might not have had that much of a window into the real cost of your bonds.

Underwriting spreads

Getty Images

When a broker-dealer buys or sells bonds for investors, it can either trade the bonds from its own inventory or it can trade in the open market for you.

If your broker arranges a bond trade in the open market, then you receive a disclosure that shares the details on the transaction costs you paid.

However, if your broker trades the same exact bond out of the firm's own inventory in what's known as a "principal trade," there is no requirement that you receive a disclosure of your transaction fees — until now.

These transaction fees or "spreads" are tacked onto the price of the bond: In a principal trade of $100, you might just see that you're paying $102 for the security. If you sell it back to the firm, you're getting back $98.

"You don't see that $2 markup or markdown, you just see that that you bought or sold it for that price," Hauptman said. "Now, firms have to show you the percentage and real dollar amount of what the bond costs to trade."

Under the new rule, consumers receive the disclosure after the trade.

"We'd like to see pre-trade transparency so that you know what the markup or markdown will cost and you can compare different broker-dealers," Hauptman said.

Fees on bonds vs. stocks

Photo by fizkes via Getty Images

Trading costs are much higher when it comes to bonds versus equities.

A 2007 paper by Michael S. Piwowar, one of five commissioners of the SEC, cited research in which he found that the average effective spread on a $20,000 retail municipal bond trade was nearly 2 percent of the price.

In comparison, a similarly sized trade of 500 shares of a $40 stock had a spread of about 80 cents per share or $400, Piwowar found.

Because firms haven't been upfront about the cost of principal trading with bonds, some customers have been under the impression that the transaction is free.

"In this case, the dealer's customers may mistakenly conclude they aren't incurring any trading costs for this bond while, in fact, they are incurring the highest trading costs in the market," Piwowar wrote.

"The lack of transparency allows dealers to obtain a great deal of investable wealth from unsophisticated investors," Piwowar wrote.

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