How a Broker is Paid Selling Bonds

At PCA, our goal is to represent our clients as a Fiduciary without conflict of interest as to what investments we recommend. We do not receive compensation from any investment in our client portfolios, or from our custodian Charles Schwab Institutional. Our investment management compensation is paid directly, and transparently, by our clients. There are no investment or trading commissions paid to us.

This may not be the case with Brokers in the industry that do not represent their clients as a Fiduciary. Brokers can be paid commission, and those commissions are not always transparent. Bonds are a good example of this!

There are a couple helpful facts to understand about bonds. Bonds have a “face amount”, $25,000 for example, and the bond is worth exactly the face amount at maturity. Interest rates affect bond prices. If interest rates increase and you want to cash in your bond, prior to maturity, then you will almost certainly have to accept a price below what you bought the bond for. This “Interest Rate Risk” is important to understand how it affects Bond Funds and individual Bonds.

When you view a brokerage account statement, the face value of the bond is typically listed as the “Maturity Value”. If interest rates have gone up since the bond was originally issued, then the current value will be lower than the face amount. If interest rates have gone down, since original issue, then the current value will be above the face amount. Regardless, at maturity the bond will be worth the face value provided the bond issuer doesn’t default.

The longer the time frame until maturity, the greater the “interest rate risk”. Put another way, if interest rates continue going up, then bonds having a long time until maturity are likely to decline significantly more than bonds closer to maturity. When we were experiencing record low interest rates for years, brokers were selling longer maturities because the rates are higher. Of course, everyone wants a higher rate versus a lower rate. However, bonds with longer maturities have higher interest rate risk. Bond holders often feel trapped holding on to bonds until a far-off maturity in a rising interest rate environment because the bond price has declined significantly. If liquidity is desired, you would have to liquidate at a steep loss or “discount.”

Brokers “markup” the cost of a bond for their commission. I will use public information from Edward Jones to illustrate this point. This is a link to the SEC website describing why Edward Jones paid a $20 million fine in 2015:https://www.sec.gov/news/pressrelease/2015-166.html

This is directly from the Edward Jones website (source: https://www.edwardjones.com/us-en/disclosures/account-fees/fees-compensation/fixed-income-fees):

“Edward Jones may act as a principal in a bond transaction, which means we buy bonds and hold them in inventory for our clients to buy from us. When we act as principal, we receive a commission (also known as a markup/markdown) that is included in the price you pay for the bond. This commission typically ranges up to 2% for buy transactions and up to 0.75% for sell transactions. When we sell newly issued bonds, CDs and preferred securities during an initial public offering ("IPO") period, we receive a selling fee that is built into the initial offering price; we may also receive an underwriting fee and management fee. For general details about fixed income investments, see "Important Information Regarding Your Accounts with Edward Jones.” (End of website information)

So, the Broker is paid to buy and sell. When their commission is “included in the price of the bond”, then the client doesn’t see this cost! The client pays more than what the bond is actually worth in the marketplace. Example; You pay $30,000 for a bond and do not see any commission or fee on your statement. However, the bond was actually trading for $29,000 and marked up to $30,000 when purchased. The broker is paid $1,000 for the sale, but you don’t see the $1,000 cost anywhere! You would have to read, and understand, the fine print which I have provided you in this article.

Edward Jones is just one of many brokerage firms selling commission-based investment products in this way. Clients should be concerned about fees and cost. We are as well. Unfortunately, clients often only recognize costs and fees they see on their statements. As a Fiduciary, our goal is to align our objectives with our client’s objectives. Our fees are transparent and unrelated to investment choice or transactions.