Welcome to the third installment of our master class on bond ETFs, where we go beyond the basics to help investors understand the mechanics and benefits of these innovative funds.
So far, we’ve covered the three key elements of a bond ETF and the differences between bond ETFs and stock ETFs.
In both blogs, we touched on the concept that individual bonds trade over-the-counter (OTC), and that this has some important implications for bond ETFs.
Today we’re going to take a deeper dive into that concept and contrast the OTC market with how bond ETFs trade.
We’ll start by talking about how a bond trades – take a look at the illustration below:
Let’s say Customer A wants to buy a bond. In the OTC market, here are the general steps he would need to go through:
- Customer A calls Broker A to ask if she has the bond available for sale.
- If Broker A doesn’t have the bond, Customer A then needs to call Broker B (and potentially C, D and E) until he finds a broker that offers the bond he’s looking for.
- When Customer A finds a broker that has the bond, he asks at what price the broker is willing to sell it.
- If Customer A is unsatisfied with the price, he then needs to call more brokers until he finds one that offers both the bond he’s looking for and an agreeable price.
- Ideally, Customer A wants to find at least two brokers who offer the bond in order to make sure that the price is fair relative to what other brokers offer.
That’s a lot of phone calls and negotiations. Not to mention the fact that these brokers are taking calls from other customers throughout this whole process, negotiating prices that Customer A has no way of seeing. This can lead to large disparities in the prices paid by different investors. A broker can sell the same bond to both Customers A and B at the same time — but at different prices.
Perhaps most importantly, Customers A and B have little visibility into the market. They can’t see what brokers are offering the bond they want without making a lot of phone calls. And even then they have no way of knowing if they got the best price available. Was there a Broker C or D that offered a lower price on the same bond? They have no way of knowing.