The Institutional Advantage When Buying and Selling Bonds

Thornburg Investment Management

Josh Gonze

February 25, 2010

When selling bonds, retail investors are at a disadvantage compared with institutional sellers, such as mutual funds.

When an individual wants to sell bonds in his retail brokerage account, he calls his broker and requests a quote. The client is soliciting bids from only one broker/dealer. His broker obtains a quote from the firm’s internal trade desk and relays it to his client. Typically, the retail investor takes whatever price the dealer quotes him, usually around half a percentage point ($5 per bond) to three percentage points ($30 per bond) lower than the price an institutional seller could have obtained. The quote contains a mark-up for the trade desk and a sales credit for the broker, and may be a low-ball number to begin with. The retail investor isn’t a seasoned bond trader who can interpret bond prices. He’s at the dealer’s mercy.

A 2003 study of bond trade spreads by the Municipal Securities Rulemaking Board found very large differences in bid/ask spreads, based on size of the block traded. For blocks less than $50,000, the bid/ask spread was 213 basis points, compared with only 23 basis points for blocks larger than $1,000,000.

Contrast the retail selling process with what occurs when a mutual fund manager sells bonds.

When an institutional investor such as Thornburg wants to sell a bond, it enjoys economies of scale, has the expertise to judge what bonds are truly worth, and has numerous methods for accomplishing the sale. Thornburg interacts with more than 100 dealers. We select a selling method based on how quickly the bond needs to be sold, the type of bond, whether we desire anonymity, whether we prefer to offer the bond or solicit bids, block size, and whether the ultimate buyer is likely to be another institution or retail investor.It’s easy to explain by example. Suppose there is a broker/dealer named Jones Securities. Here are five methods Thornburg could use to sell bonds.

• Thornburg shows the bonds to Jones on an exclusive basis at an offered level. If Jones has a “natural buyer,” meaning a buy-side shop that wants the bonds, Jones can buy the bonds from Thornburg and re-sell them to the institutional buyer or retail accounts with a mark-up. This method has the lowest middleman cost. But it often doesn’t work because Jones cannot identify a natural buyer. Thornburg does a blast offering – we offer the bond to a group of dealers, anywhere from 2 to 100 or more, who in turn show the bond to their clients as a “customer offering.” A variation of this is to show it to one dealer and ask him to show it to a brokers’ broker, who in turn shows it to the Street. Thornburg shows the bond to Jones at an offered level and instructs Jones to offer the bonds on various platforms for fixed-income trading. There are web-based platforms such as MuniCenter and BondDesk, and there is Bloomberg pick, a non-web platform that reaches dealers but not retail investors. Offering a bond on platforms must be done on an exclusive basis, meaning Thornburg can only show the bonds to one dealer, to avoid the dealers clashing in the market as they attempt to sell the same bonds. This method often works well for difficult-to-sell bonds that retail brokers can buy in odd lots for resale to retail. A variation on this method is for Thornburg to offer the bonds directly on MuniCenter and BondDesk (but not pick, which allows only dealers to offer bonds).Thornburg uses Bloomberg to put the bond out for bid. A bid-wanted message is disseminated to the Street. Dealers are allowed a certain amount of time – typically between one and three hours – to submit bids to Thornburg via Bloomberg. This method exposes to the dealers that Thornburg owns the bonds and is a seller. This method works well for higher-quality bonds that dealers can rapidly evaluate and price, and less well for story bonds.
• Thornburg asks Jones to put the bonds out for bid with a brokers’ broker. The brokers’ broker disseminates the bid-wanted to the Street. This is known as a “Street bid-wanted.”  This would protect Thornburg’s anonymity. A variation on this method is for Thornburg to skip over Jones and go directly to the brokers’ broker with the bid-wanted. This cuts out the middleman but may damage the relationship with dealers, who prefer that institutional customers and brokers’ brokers not have direct contact.

Thornburg’s Buying Advantage

When it comes to buying bonds, mutual funds enjoy many advantages compared with retail investors. Those advantages are passed on to shareholders in bond funds.Why do institutional investors have the inside track?

• Access to bond issues that are not sold via retail distributionDaily participation in the marketAbility to buy on the bid side of the bid/ask spreadBroad knowledge of the marketExpertise in assessing riskThe ability to buy in large block size for economies of scaleFull-time attention focused on the marketTechnology such as Bloomberg terminals and portfolio management systemsSuperior knowledge of how various types of bonds are trading
• Interact with hundreds of dealers rather than one or two

Often we can acquire better bonds for a lower price, compared with retail investors. We see it frequently in both the primary and secondary markets. Once we purchase a block of bonds, it’s delivered to one or more of our mutual funds and separate accounts at cost – no mark-up.

The bid side. In the secondary market, Thornburg acquires bonds the same way that broker/dealers acquire bonds. We submit bids in response to “bid-wanteds” that are disseminated via Bloomberg and the brokers’ brokers. We typically buy on the bid side (the low side) of the bid/offer spread. Retail typically buys at the offered side (the high side). The offered side contains a mark-up for the dealers’ trade desk and a sales credit for the retail broker. The mark-ups can be substantial if the dealer is taking significant risk to carry the bond in inventory or if the bond passes through several dealers’ hands before selling to the end customer.

Price discovery. Daily participation in the market is a price-discovery tool. It informs us of the real market value of a bond. There’s no substitute for trading bonds daily and discovering for yourself what a callable, 10-year, A-rated utility bond in Florida is worth compared to say, a noncall, 10-year, aaa-rated utility bond in Texas. Retail investors often have no idea where particular bonds are trading. The bond market is really a collection of markets for thousands of unique bonds.

Compare. We constantly compare the primary and secondary markets and shift our purchases to whichever market is cheaper. Sometimes the better deals are in the primary while in other periods, the secondary is more attractive. We also constantly compare different regions, sectors, and issuers with one another.

Pushback on dealers. In the primary market, retail buyers are price takers. A deal is offered at a specific price and yield, and the retail investor typically says yes or no. Institutional investors can often, but not always, push back on the terms. We can request a lower price, a specific block size, better coupons, or preferrable redemption language. If the deal is oversold, then our request will be denied. But if the deal is struggling, often we can get the deal restructured to suit our preferences.

Wholesale prices. For our mutual funds, we trade in larger blocks, e.g. $2,000,000 or $20,000,000. When we are pursuing a block of bonds, often we have slim competition – perhaps only a handful of interested buyers. The brokers who sell us bonds typically work for less than one-tenth of a percent markup, whereas dealers selling pieces less than $100,000 often work for 10 or 20 times the institutional mark-up.

The views expressed by Mr. Gonze reflect his professional opinion and should not be considered buy or sell recommendations. These views are subject to change.

Before investing, carefully consider each Fund’s investment goals, risks, charges, and expenses. For a prospectus containing this and other information, contact your financial advisor or visit thornburg.com. Read it carefully before investing.

 

(c) Thornburg Investment Management

www.thornburginvestments.com

 

 

 

 

 

 

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