Macro Mondays: Fixed Income (Part 2 of 5)
Welcome to another edition of Macro Mondays here on GradMoney! This week we will continue the discussion of fixed income by taking a look at how fixed income investments are different from stocks and who the major creators of these products are.
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The U.S. bond market is about twice the size of the domestic equity market. Still, fixed-income securities don’t get as much investor (or media) attention as the stock market does – primarily because bonds don’t offer the same, exciting return potential as stocks. In this section of the tutorial, we’ll look at some of the ways fixed income differs from equities, who the major players are, and the advantages and disadvantages individuals face when trading fixed income.
How fixed income differs from equities
There are numerous differences between the fixed-income and equity markets. When it comes to trading, however, there are several that are particularly important. One is the sheer number of securities available in the fixed-income market. If you’re interested in investing in Apple, for example, you have just one stock to consider: AAPL. But you would have dozens of choices if you wanted to invest in Apple bonds. Similarly, investors in the Treasury market have hundreds of offerings to choose from.
The positive aspect of having so many different issues to choose from is that you can usually find a security that very closely meets your needs. The flip side, however, is that you need a process for determining precisely what your investment needs are – and then be able to screen the fixed-income universe for the security that most closely matches those needs.
Another major difference between fixed-income and equities involves price transparency. Stock prices are relayed instantly to all market participants via live streaming quotes. If you’re trading stocks, you can be reasonably certain you’re getting a fair market price when you buy or sell (of course fair market price and intrinsic value can and often do differ greatly). In the bond market, however, trades are executed dealer-to-dealer or dealer-to-investor. With no central trading place, bonds are sold mainly over-the-counter (OTC). With no record of the transaction prices in the bond market, you might not know what price you’re getting until after a trade is filled.
This is set to change with the implementation of sweeping new financial rules known as MiFID II (Markets in Financial Instruments Directive), which went into effect in Europe on Jan. 3, 2018. Although the controversial legislation applies to all European-based banks and other financial institutions that trade certain assets including bonds, the rules will also apply to firms that do business in Europe – including big U.S. banks with substantial European operations.
Under MiFID II, new transparency rules require that the trading prices for some bonds be published soon after a trade is made, and that bid and offer prices – and market depth – be made public in advance. While trade data still won’t be as “real time” as it is in the equities market, these new rules will help level the playing field for retail investors.
Also worth noting: The sheer volume of issues outstanding means that some bonds may not trade for days, weeks or even months at a time. This can have a profound effect on liquidity, and make it difficult to get into or out of a trade when you want, or at the price you expect. Of course, there are plenty of stocks, too, that trade under low volume – so the problem doesn’t apply only to bond traders. Still, it’s something to be mindful of when trading either bonds or equities.
Who are the major players in the fixed-income market?
Another difference between the fixed-income market and the equity market is the importance of institutional investors. While it’s the large institutions that move prices and dominate trading in either market, retail investors are generally far more active in the equity market than they are in the fixed-income market. Because of this, investors executing small stock trades generally don’t suffer a penalty (i.e., don’t pay more), relative to the institutional investors trading larger sizes. This isn’t true in the fixed-income market.
Because institutions so thoroughly dominate the fixed-income market, the average trade size is quite large (a round-lot trade in fixed income is often millions of dollars' worth of bonds). Retail investors buying odd lots, or amounts smaller than $1 million, might find themselves paying a penalty, relative to the price they would receive for a larger position. Because fixed-income returns have historically been lower than equity returns, a seemingly minor price discrepancy when buying or selling can actually wind up "costing" an investor a substantial portion of his or her potential returns over time.
Advantages individual investors have
The preceding paragraphs discuss some of the challenges individuals might face when investing in the fixed-income market. However, there are also several advantages that smaller investors may have. One of these perks is that long-term investors don't have to pay attention to daily market movements. This freedom allows individual investors to seek out attractive long-term opportunities, without worrying about short-term market fluctuations that might occur.
Another advantage that individuals might have is that they can consider a wider range of issues than many institutions. Institutional investors often have extremely rigid investment policies that dictate what issues they can and cannot buy. By being slightly more flexible, an individual can seek value in the bond market wherever it occurs.
One other benefit that individual investors have is that they can choose not to trade when valuations aren't attractive. A bond mutual fund manager or other institutional investor generally doesn't have a choice whether to buy bonds; cheap or expensive, the investor must purchase bonds as new money flows in and as old bonds mature. An individual can choose to allocate more money to the stock market, however, or to a money market fund, as opposed to buying bonds if he or she finds that valuations are not attractive. Similarly, when prices appear reasonable, individuals can choose to purchase more bonds for their portfolios. This flexibility doesn’t exist for most institutional investors, and is a significant advantage for the individual.
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