By Gordon Pape, Editor and Publisher
Our rigged bond market needs urgent attention.
If you’ve ever tried to buy a bond for your account, you know how frustrating it can be. There’s nowhere to check current prices – no central market place like the TSX for stocks. Brokers carry some bonds in inventory but your adviser may not have the specific one you want. If it is available, it will probably be at a price and yield that bear little resemblance to what you saw in the newspaper, a newsletter, or on-line. That’s because the broker is acting as a dealer and can sell bonds at whatever the traffic will bear.
The standard advice is to shop around when buying bonds but that’s easier said than done. You may be able to get a quote from your own broker (broker A) but if you pick up the phone and cold call the bond desks at broker B and broker C, you’ll probably be asked to set up an account before they’ll talk to you.
In short, it’s an opaque market that designed strictly for institutional players. Retail investors aren’t welcome. That’s the main reason we stopped making specific bond recommendations in The Income Investor. Readers complained that they couldn’t acquire the specific securities we recommended or that the price was out of line with our quote.
The Ontario Securities Commission says that more than $10 trillion worth of securities were traded in the fixed income market in Canada in 2014. Most of that trading was done by institutions.
In a report published earlier this year, the OSC said that the current structure of Canada’s fixed income market gives institutions “significantly more information and bargaining power than small investors”. As a result, direct participation in the bond market by small investors is very low, forcing them to use ETFs or mutual funds to buy fixed income securities.
“The secondary market for bonds is a negotiated market,” the report says. “Both retail and institutional investors typically access the market through a dealer that brings together buyers and sellers. Trading is decentralized and takes place OTC (over the counter) through dealer networks, one reason why the fixed income market is less transparent than the public equity market.”
It goes on:
“Since bonds trade OTC, retail investors have limited access to pricing and trade volume information; have little ability to determine the components of the retail price; and have limited access to many bonds. Asymmetric information in the fixed income market places retail investors at a disadvantage relative to other participants. Furthermore, a significant number of bonds, ranging from 23-47%, are privately placed and only available to accredited investors.”
In other words, the deck is stacked against us, big time.
The report, which can be read at www.osc.gov.on.ca/documents/en/Securities-Category2/20150423-fixed-income-report-2014.pdf, identifies three main problems in the fixed income market as it relates to small investors.
- Transparency. When they buy stocks, retail investors have access to a wide range of data including up-to-the-minute pricing, trading volume, and bid-ask spreads. The bond market offers none of this.
- Liquidity. The retail secondary market is very limited. Many institutional investors hold their bonds to maturity.
- Lack of centralization. Unlike the equity markets, there is no centralized information source for bonds. “Information must be patched together from individual dealers.”
The report notes that United States has the most transparent bond market in the world but it still fails retail investors on some levels including fee disclosure. When you buy a stock, the commission is clearly shown on the transaction statement; with a bond it is buried in the total pricing. The report itself makes no formal recommendations on ways to make the bond market more accessible to retail investors. But an accompanying staff report identifies three areas of focus.
- Facilitate more informed decision-making among all market participants, irrespective of their size. The Canadian Securities Administrators (CSA) has introduced new cost and reporting rules for bonds that will be fully implemented by July 2016. They are supposed to help retail investors better understand the cost of their fixed income transactions. OSC staff will monitor their implementation and effectiveness.
- Enhance market integrity. One of the problems we face in this country is a multiplicity of regulatory organizations. Another one, the Investment Industry Regulatory Organization of Canada (IIROC), recently adopted a rule that requires dealers to report trade information for fixed income products for surveillance purposes. The OSC it supports this rule and will oversee its implementation.
- Evaluate whether access to the market is fair and equitable. The staff report notes that IIROC already has a fair allocation rule for new issues in place. However, “it prohibits allocations of new issues to non-client accounts ahead of clients and does not cover allocations among clients. Staff will work with IIROC to gain a better understanding of how investment dealers are currently allocating new fixed income issues, which will help determine what, if any, regulatory response is needed.”
So here’s what it all boils down to. There is wide agreement that the bond market is a closed circle, with participation mainly confined to a limited number of large players. There is also agreement amongst regulators that this needs to change and that retail investors should be given a fair shake. But the reform process is bogged down in bureaucratic red tape, with several agencies working independently, if not at times at cross-purposes.